Friday 10 February 2012

Europe's economic woes

I've seen some people suggest that the Australian Government didn't need to stimulate the economy to offset the effects of the GFC. They argue that cutting interest rates alone would have been enough. I think their argument is rubbish.
  • Monetary policy has a lag. Cutting interest rates today will have negligible effects on demand in the short term. Indeed some people argue that it can take 18 months to flow through the economy. By then the economy will be in deep recession and unemployment and rates of business failure will have increased significantly.
  • The point of cutting interest rates to stimulate economic activity is two fold. One, people and businesses will pay less in interest on existing borrowings and so will have more money available to spend on other goods and services. Two, lower rates are more likely to encourage people and business to borrow money and spend it. However the reality is that when the economy is doing poorly many people and businesses become fearful of the their economic future. They're more likely to try to reduce their debt and save rather than spend and borrow.

In Europe must not ignore the tough lessons of history Ross Gittins somes up this latter point well:
One thing the central bank can do is cut interest rates to encourage borrowing and spending. In normal times this is usually effective, but in really bad times a lot of people are too uncertain about the future to want to borrow and expand no matter how low rates are. And if interest rates are already very low - as they are in the advanced economies now - you can't cut them below zero.
The current Government talks about keeping the budget in surplus over the economic cycle. That doesn't mean that the budget will be in surplus every year. What it does mean is that the Government will run a budget surplus when the economy is going well, but will run a deficit if it needs to stimulate the economy when growth is too low.

So why run a surplus? Two reasons: it helps to control inflation; and it means that the Government has enough funds available to stimulate the economy when it needs to.

The problem for the USA and many countries in Europe is that they've been running deficits when their economies have been strong. Over time they've built up substantial levels of debt to finance their deficits. Although this was bad policy they could afford to do it because they had enough tax revenue to service their debt. However, the GFC has seen their tax revenue plummet and their expenditure increase (on things like unemployment assistance). Now some of these countries are having trouble servicing the debt they already have. They're in a catch-22 situation. They need to run a deficit to stimulate their economies. However, they don't have the reserves to pay for the required budget deficit and are having trouble borrowing money to finance it. In fact the deterioration in their budgetary position means that they are now having to implement austerity measures - increasing taxes and reducing Government expenditure. This in turn is reducing economic activity in their economies and driving them further into recession.


As Ross Gittins writes:
Their economies are still quite weak, but they want to increase taxes or - more commonly - slash government spending to get their big budget deficits down in a hurry. In consequence of this policy of ''austerity'', the European economies are heading back into recession and their deficits are getting worse.

Why are they doing something so counterproductive? Because their stock of government debt is so unsustainably high. Whereas sensible policy involves running surpluses and reducing debt during the good years, they kept running deficits and piling it up in the noughties.

When the global financial crisis struck in 2008, many had to borrow heavily to rescue their banks and then borrow even more to kickstart their economies. Their debt is now so high the financial markets have started wondering whether they'll be able to repay it.
Then you have Greece:

Of course, when a country's sovereign debt gets so high that markets will soon refuse to lend more to it at any price, it has no choice but austerity. You can renege on your debts, but you can't run a deficit if no one will finance it.

Even if some international institution bails you out, it will punish you for your profligacy by insisting on austerity. Will this make things worse long before it makes them better? Inevitably.
The other problem for Greece is that it's in the Euro. Normally a country with its problems can at least devalue its currency or try to inflate its way out of its problems. Greece can't as it shares its currency and interest rates with the other Euro zone countries.

Back to the other countries. Ross Gittins again:

But most of the European countries aren't in those dire straits, so why are they slashing spending? What they should be doing is promising and laying plans to reduce their spending down the track, as their economies recover and can take it in their stride.

Why don't they? Because, after decades of fiscal indiscipline, they don't have much credibility when making promises to be good tomorrow. But that doesn't change economic reality: cut when the economy's weak and you make it weaker. The answer is to find ways of making their promises more credible.

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