Austerity - The Consequences

I am going to start this post with a comment from Suzy, given on my last post:

Cynicus what do you think about the theory that nothing now can save us. As is being made clear the austerity measures - that you seem to support are causing deflationary problems on a massive scale in the countries they are being used in. This means the markets are jittery about possible double dips and jittery about Greece entering a horrible recessionary scenario.

So it seems we are damned if we cut and damned if we don't. And what is worse - default or ten years of depression - which is what some commentators think Greece now faces.

The problem identified by Suzy is indeed a real problem - damned if we do, and damned if we do not. It will not have escaped the notice of readers that the word 'austerity' appears to be the word of the moment. This is a report from Forbes which is headlined as 'Austerity - the New Worrisome Buzzword':

Dictionaries define austerity as economic restriction, scarcity, sternness, hardship.

No wonder then that people in Greece and Spain are taking to the streets in protest of the austerity measures required of countries accepting aid from the EU/IMF rescue plan announced a week ago. Among the austerity measures are pay cuts, cuts in pensions, later retirement ages, and fewer government services.

The push for austerity adds to concerns that the rescue from record government debt loads may be as negative for the economies of Greece, Portugal, Spain, and Ireland, and therefore the fragile overall European economy, as actual defaults on the debts might have been.

In the U.S., worries over the austerity programs in Europe have overwhelmed the positive U.S. economic reports that have been coming out. Among the worries is that bank and investor losses on government debts in Europe could undermine confidence in global financial systems again.

The report goes on to say that the State of California is also implementing 'austerity' measures, and it is also apparent that 'austerity' measures are also in prospect in the UK. Ireland has already implemented such measures, and Italy appears to be in process of measures. What we are seeing is a grand beauty contest, in which sovereign states are in competition, one with another, as to who will be in receipt of further credit. The exception, of course, is the US, which is still relying on the irrational belief that it is a 'safe haven'. Regular readers will know that I have always expected a reaction to crisis would be to initially flee to the illusory safety of the US, and this is what has taken place.

What we are seeing is that we are now in a situation in which 'austerity' measures are taking place simultaneously, and that demand for goods and services will (in aggregate) start to fall as the austerity measures bite. This has led to a lot of talk about Fisher's debt deflation theory, and fears of deflation are commonplace in many reports. The following is a sample of the kind of discussion that is very common:

Germany is pressing other eurozone countries to push ahead with brutal austerity measures to slash their budget deficits. Spain, Portugal and Greece have already announced their austerity measures, while Italy is expected to soon announce tough budget cuts. Meanwhile, to comply with its new balanced budget laws, Berlin will have to slash its budget deficit by about $US13 billion each year for the next five years.

There are worries that this strong contraction in government spending in the eurozone will force many economies into recession, making it even more difficult for countries to collect the tax revenues they need to stabilise their debt levels. Steep declines in economic activity will put additional downward pressure on prices and already there are signs that prices are falling in Portugal, Spain and Ireland while underlying inflation in Germany is close to its lowest levels in more than a decade – making it even more difficult for countries to service their debts.

I suggest that you re-read the second paragraph. The argument is this:

1. If a government reduces the quantity of borrowing, the economy will contract.
2. If the economy contracts, there will be less tax revenue.
3. If there is less tax revenue, debt servicing will be more difficult.
4. Stabilising debt levels needs borrowing to be continued.
   

All I can say to this extraordinary thinking is ??????! Are they serious? In order to stabilise borrowing, there is a need for more borrowing, to increase activity, such that some of that borrowing ends up back in the hands of the government as tax revenue so that they can service the borrowing that they are undertaking. Apparently, this will stabilise debt levels.

Within the article quoted above is exactly the dilemma proposed by Suzy. Damned if they do, and damned if they do not. Governments have the option of continuing the high borrowing until, finally, investors take fright, or they cut back borrowing to sustainable levels, and see the GDP go down as a result of reduced borrowing - and then see the tax revenues fall, causing further tightening, and all the while seeing their debt to GDP ratio move in the wrong direction, thereby further alarming investors.

Within this scenario is a problem, which I now feel I am endlessly repeating. This is that countries have mistaken growth in GDP for real growth, when the reality that the growth was not in their ability to generate wealth internally for consumption, but a growth in their consumption of the output of other countries. When you borrow $1 billion a year from China, you can purchase Chinese goods to that value. However, as with all borrowing, China would expect to get the $1 billion back, and with interest, which means an equivalent amount of output from your own economy. If we think of it in simplistic terms, we are borrowing 50 million colour televisions from China, and must repay in (or the equivalent of) 55 million televisions. When we make our repayment to China, unless we have an economic miracle, we will have less of our output for ourselves. A proportion will be returned to China.

What we have in effect is a situation where we appeared to be 50 million colour televisions richer, and now we no longer have these, and in addition, we are having to return some of our own output of colour televisions to China (I know, we do not make them anymore). We immediately feel a loss as we commence living on our own output, and that output available for consumption is further reduced due to having to apportion some of it to repay our creditors. The 50 million televisions were never our output, though we believed this to be the case. Because we never realised this was not our own output, we are now in a situation where there is resentment at the prospect of falling living standards, and reaction against living within our means, and paying our debts.

What we now have is a situation in which we are having to face some tough decisions. For the countries that have the ability to devalue, they can do so. However, if they want to continue to have access to credit, they must devalue at the cost of paying much higher interest on their debt. In particular, where government borrowing is in the economy's own country, the repayment is made in devalued money (think of returning three quarters of a television in return for the one that was given as a credit) and, unsurprisingly, creditors will protect themselves against the risk of you doing this again. In addition, this lowers the standard of living of everyone in the country which has the currency devalued. I always give the example of the person who enjoys imported Belgian beer having to pay more for their beer to illustrate this. This simple pleasure takes a greater proportion of your wages, and you are therefore literally poorer.

The above scenario is, of course, inflationary, and we are seeing climbing inflation in the UK, which has seen a steady devaluation of the £GB. The inflationary effects are taking place despite the contraction of the economy. A long, long time ago, I asked myself the question of whether we could expect inflation or deflation. I pointed to a falling £GB outstripping the impact of the contraction of the economy, and this is what has taken place. In a letter to the Chancellor, explaining inflation being above target, the Bank of England has recognised this impact (belatedly).

Interestingly, the Bank of England is still talking of 'spare capacity' in the economy - what they are not talking about is whether that capacity might have any utility. In a crude example, if we think of a shop worker who has been made redundant, how might the worker be spare capacity. If retail was structurally over-represented in the economy, and the economy has corrected the credit fuelled over-capacity, what is this worker 'spare capacity' for? Can they go and work in an engineering works? The same might be said of a wholesaler to the catering trade, which has seen business grow at a rate fuelled by excess credit expansion. They might have 'spare capacity', but it is pointed at the wrong sector.

At present, the only way that this 'spare capacity' might be utilised is if a government keeps pouring borrowed money into the economy to soak up this spare capacity. However, the reality is that the capacity must eventually disappear. At some point, the credit will stop, and we are seeing this taking place. For many countries, they are under threat of a complete halt to further credit. The only solutions to the problems is to re-balance their consumption and output, and that means to move from living on credit to generating surplus to repay the credit. The problem is that this can not be achieved overnight, and without considerable economic destruction. The expansion of sectors that were reliant upon credit will have to shrink to a size which is appropriate to the economy.

The solutions to these problems are varied. In the countries locked into the Euro area, in the end, it must mean wage cuts which will allow them to export. In countries that have currency independence, they can 'inflate their way out of trouble' through devaluation, thereby commencing a process of increasing inflation internally, and thereby indirectly lowering wages to allow their economies to become competitive. In doing so, they will pay a high price for any further borrowing. You may note, that this still means reduction in wages, and simply means that the wage cut is not in quantity of money but undertaken through lowering the value of money.

However, there are signs that inflating out of trouble may not be the chosen solution. It seems that austerity is the more probable route, and that will mean wage cuts. It may be remembered that making a saving of £50,000 a year with one redundancy is the same as cutting the wages of many workers by £1000 each. In both cases, the wage cut is real, only in the former case it is concentrated in one person (the provision of unemployment benefits is, of course, a complication, but we will leave that alone for the sake of simplicity). There are some problems in implementing across the board wage cuts, such as minimum wage laws and the provision of benefits. I will explain.

In the case of a minimum wage, the floor of a minimum wage worker will also influence the wages of higher paid workers, such as their supervisors, or the manager who manages the supervisor. In each case, there is a necessity of a differential and a floor on the overall wages is therefore set by the minimum wage. Benefits also create a minimum wage as follows (from my first post, A Funny View of Wealth):

As mentioned before, all things in the UK are not equal due to the minimum wage, but also because the UK employer needs to compete for labour with the UK benefits system (which is an indirect minimum wage that applies to anyone entitled to social welfare benefits). This system allows an individual to remain economically inactive, or to choose an option of accepting a low paid job for very little real remuneration despite a major increase in the expenditure of their labour. In such cases the value of the labour expended is far below the minimum wage as it needs to be calculated as the weekly pay minus the benefits, to give an actual wage for the work done. The rational person in this situation might reasonably ask whether the loss of their free time to work is worthwhile for what will often be little financial incentive as, in this situation, the UK worker is often working for extremely low wages[10].

The problem with these minimum wage effects is that they have potential to displace lower wages into high unemployment. It encourages a system of haves and have nots. The upside is that it encourages organisations to do more with less labour, thereby encouraging improvements in productivity, but does so at the cost of throwing individuals to the scrap heap of unemployment. Whatever happens, however it takes place, wage cuts are on their way - whether concentrated into unemployment or shared more equitably over the workforce.

The real problem in these scenarios is that everyone seems to be looking to exports as the route out of the global economic crisis, whether China, Spain, the UK or the US. Just looking at the US and China, China has enjoyed an export boom partly based upon credit provision to the US, and its industry is directed in part to servicing those US customers. In other words, China has used massive provision of credit to support an export sector that does not have enough customers. As such, it must also eventually adjust. As 'austerity' takes over, their export sector will suffer. As such, China will do everything it can to support the export sector, rather than risk unemployment at home. They need to keep exporting. At the same time, the US are seeking ways to compete in export, and are now facing a China that seeks to continue to win in the export game. A similar scenario can be painted for the PIIGS and Germany.

In the examples above, I am simplifying, but the essence of the problem is as I have put it here. Competition on labour costs is on its way, with the aim of winning the export game. However, not everyone is going to win in an export game when many of the markets that previously drove exports are going into decline. Whilst continued borrowing by debtor countries might prop the system up for a little while longer, it does not alter the fundamental imbalances that the credit boom created. All over the world, there are industries pointing at markets that simply can not afford to consume the goods they have been consuming in recent years. They do not have the capacity to both repay and consume at the same rate as they were when the credit taps were wide open. As these markets contract further, as austerity bites, each country will seek to generate competitive advantage. In the case of the major debtors, they will have to, one way of another, cut their wage bills.

But what happens if more and more countries are doing the same thing - whether directly or indirectly through devaluation? How does it end?

The answer to this question lies in the eventual re-balancing of the world economy, and in particular a re-balancing in the allocation of resources available for consumption. I have given an explanation of why this is a problem in earlier posts, and it is too long to detail here. In short however, the amount of commodities in the world has yet to catch up with the new input of labour represented by the emerging markets. If the labour force increases without a commensurate increase in resources, then there must be a period of hyper-competition. This hyper-competition was emerging but was masked by the credit boom. However, if you want to understand this, I suggest you read one of the posts on the subject, such as this one on Huliq.

Having said that there should be a re-balancing towards the emerging markets, this is to ignore one thing. The losers in this process do not want to see this happen. This is where politics, and in particular geopolitics come into play. How the game might play out is, in many respects, dependent upon how world leaders address the problem. How they might react as the economic crisis continues to unfold, and fully reveals itself, is going to be highly unpredictable.

Note 1:

Within this mess, we have the further complication that the US is seen as a law unto itself. Whilst they have similar structural problems to many countries faced with crisis, their problems are still being hidden under the irrational rush to safety to US assets. They are still on the path of borrowing to support their economy, and to generate the tax revenue to support their repayments, and to gradually lead their economy to the point at which investors finally take fright. Where California is leading, the rest of the US will eventually follow.

Note 2: Some replies to comments on the last post

Ginger Tosser: Yes, the US is currently a safe haven, but they have the same problems as elsewhere......it is only a matter of time.

Kiwi: I long ago proposed Norway as the best bet.....stable government, resource rich, large sovereign wealth fund....but even then we can never be sure in the chaos that we are now seeing.

Ian: I have a few moments where I have metaphorically held my breath, asking is this the big plunge?

Anonymous on the Scorched Earth: There has been considerable commentary on the state of what was inherited by the new UK government. It is a good opportunity to get the skeletons out of the cupboard and address the real scale of the problems in the UK. I have not yet commented on the election result, as I am waiting for more firm policy details.

A Real Black Person (yes, that is the commentator's posting name): I liked your pithy comment on Dubai, as follows:

But still, it makes one wonder what compelled them to start building very lavish and exquisite real estate properties for rich people that don't exist?

An extreme example of pointing in the wrong direction, unless they manage to market these to the new wealthy....

General: I have worked up the list of comments, and that unfortunately is all I have time for. However, some interesting links and comments as ever....I am always impressed with the quality of the comments.

Note 3: There is an error in the Huliq article, if I recall correctly. A section should read 'zero sum game', not 'zero sum gain'.