The problem in trying to see events moving forwards is we have still not seen the end of maneuvering of policy-makers, whether governments or the ECB. The real question is to ask whether the ECB will hold firm against a massive bout of quantitative easing? If it does not do so, it may just be possible that the crisis can be delayed, but at with a potentially larger crisis down the road. However, I suspect that the Germans will simply not allow it.
If we can assume that the crisis bumbles forwards, with no significant action from the ECB, the situation will become ever more painful. The first concern is that there does not appear to be any sources of a bailout that will be large enough to cover the spread of the crisis into countries such as Italy. The Chinese were seen as a hope, but they do not appear to be playing ball. However, I emphasise 'appear', as the Chinese will likely dive in if they can use the opportunity to strengthen their economic position versus the EU:
China had offered help in return for European support to grant it either more influence at the International Monetary Fund, market economy status in the World Trade Organisation, or the lifting of a European arms embargo [...]
Aside from these obvious benefits, there would be other repercussions. China's help would mean large scale purchases of Euros, which would see the Euro harden against the RMB, thus making European exports less competitive and Chinese exports more competitive. The shift in the currencies would see stronger competition from China, and those European manufacturers that are struggling already might well be pushed underwater where China offers direct competition. In other words, it is a short term fix, with long term painful consequences.
China also has its own problems at the moment; several years ago I discussed the possibility of a real estate bubble in China, and in the last year others have expressed similar concerns. According to Forbes, this crash may well finally be taking place, with worrying implications for China's banks and also the wider economy. Also, with reduced demand for goods from China, the manufacturing sector in China is feeling the squeeze, with China's credit squeeze on its banks sending shock waves through China's informal credit provision systems. For those who follow China, they will be aware that they instigated significant credit easing in response to the economic crisis, and the result looks like a classic example of an Austrian business cycle; credit is eased, money is cheap, cheap money is allocated to the wrong sectors, bubbles form, and a bust follows.
A Euro area crisis, with knock-on effects on the Chinese export sector, might just force China back to the bailout table in such circumstances; if Chinese politicians have a sense of an oncoming bust, they will do all they can to prop up the export sector. However, with the ongoing opacity of the Chinese economy, we will have to see whether a bust is really on the way.
The problem is that there is no other source of funding that is obvious. The US is hardly going to significantly stretch its already stretched balance sheet, and many Euro area countries simply do not dare to stretch their strained balance sheets. Aside from the risk of this seeing themselves embroiled in the crisis as a result, there are political limits to how much they might commit to a rescue, as has been revealed in the pantomime of the European Financial Stability Facility. As the situation stands at the moment, it seems that there is no obvious rescuer to come to save the day.
The 'hot' news of the moment is, of course, the replacement of 'lame duck' leaders in Greece and Italy with so-called technocrats. This has presented a reprieve in the crisis as they are expected to force through so called austerity measures. For Italy, they are as follows:
The austerity measures approved by Parliament include selling state assets and increasing the retirement age to 67 from 65 by 2026. They would decrease the power of professional guilds, privatize municipal services and offer tax breaks to companies that hire young workers.In Greece, which is further down the road than Italy, and the problems facing the new leadership are:
Papademos said his first task would be to tackle runaway unemployment. He must also start chipping away at a debt load of more than 30,000 euros for each of Greece's 10.8 million people which, at 162 percent of annual output, is almost double the EU average.
Pundits say that despite representing a fresh start in tackling Greece's debt problems, Papademos will face the same two obstacles as the previous cabinet: political infighting and a public staunchly opposed to more economic pain.
After tax hikes, public wage and pension cuts and state sector layoffs, Greeks now face record unemployment of almost 20 percent and a fourth year of economic recession in 2012.
The Greek economy is in free fall, having contracted 15 per cent under existing austerity measures, says Simon Tilford, the chief economist with the Centre for European Reform in London.
It is feared that if the government defaults on its debts, it will spark a banking crisis through the euro zone.
But only time will tell if Papademos, who negotiated Greece's disastrous entry to the euro zone, can wrangle the nation's notoriously fractious MPs into line. ''Even yesterday, the old guards, at least, of both parties were not very keen to co-operate,'' George Tzogopoulos, a research fellow with the Hellenic Foundation for European and Foreign Affairs in Athens, told the Herald.
One of the most interesting points in the interactive chart is the public debt maturity. In some respects, it flatters the situation. Again from the Economist:
February looks like a crunch time for Italy, and April for Spain. However, whether the situation will spiral out of control before then is an open question. It is starkly apparent that Italy absolutely must act now to forestall default by keeping credit lines open. The problem is that, just as with Greece, as borrowing is reduced, activity in the economy will reduce, and with that reduction in activity, the sectors of the economy that were structurally built around debt consumption will become exposed as they shrink back in response to reduced spending.
And this is the problem for all the economies in the firing line; start to cut the levels of borrowing, and the current borrowing will become unsupportable as economic activity contracts. If they do not cut, new borrowing will certainly be frozen, or the price of the debt will be too high to sustain. Either way, there is no solution to the crisis, or at least none that does not involve a bailout coming from somewhere. For this reason, it is only possible to imagine the pressure being placed upon the ECB to run the printing presses.
Within this toxic brew, there are of course the politicians and protesters who do not accept austerity measures. Their basic approach can be summarised as 'the hell with the bond markets'. It is a crude caricature, but this is the basic underlying principle. In some respects, it would be a good thing if the credit lines to one of the at risk economies were cut, if only to make the point that their current economic position is reliant upon borrowing. They do not seem to realise that, if their credit is shut off, they will find out the real meaning of austerity. However, the view that somehow government spending can continue without sufficient income is widespread. This will continue to raise questions over whether so-called austerity measures might actually be adhered to.
The real point in all of this is to question exactly what austerity actually is. It is a term that is thrown around in various media, and I make the point earlier is that real austerity would only be apparent if credit to governments was shut down. It is the simple point that austerity cannot mean austerity when countries are borrowing more money in support of ongoing over-consumption. By this I mean over-consumption is consuming more than can be paid for out of your own resources. This is not, by any stretch of the imagination, austerity. Interestingly, although dictionary definitions are sometimes of limited value, there is a good definition of austerity in the economic context:
a. reduced availability of luxuries and consumer goods, esp when brought about by government policy
The interesting point is that, if we then look at the definition of luxuries, we find the following:
a material object, service, etc., conducive to sumptuous living, usually a delicacy, elegance, or refinement of living rather than a necessityIt is the concept of necessity that strikes a particularly challenging note. When we see the political maneuvering, the arguments and debates in Greece and Italy, and other European states, there is a missing question. What is a luxury, and what is a necessity?
It is a key debate that is not being addressed. I am guessing it would not be controversial to say that, over the last two centuries, governments have extended and deepened their activities into an ever greater number of domains. This has not been a significant problem, provided that enough resource was available for government, but the current crisis is implicitly saying that there is insufficient resource to sustain the current levels of resource expenditure.
This means that certain luxuries absolutely must be cut out. In order to do this, somebody needs to face up to the problem of determining what exactly is a luxury and what exactly is a necessity. In the midst of a debt crisis, it is apparent that most countries are unwilling to face this question. They are still borrowing. If something can only be afforded through borrowing, it looks suspiciously like a luxury. Note, I am not saying that borrowing is always for luxury (e.g. an individual borrowing for a life saving operation would not be a luxury), but it seems improbable that all of any modern governments' functions might be necessary. The crisis is revealing that, however framed, there are functions that are simply unaffordable.
It is fundamentally a problem of the politicians. They have their 'political philosophies, their 'causes', and their 'departmental interests', an eye on specific sectors of the electorate, and on top of this is simple inertia. That government must do x has become a state of mind, along with the belief that x is an absolute necessity for the government. In other words, austerity is not austerity. At best, it is nibbling around the edges of luxuries. I do not propose here to say what is a luxury and what is not, as that really is a question that should be one that is being questioned through democratic institutions. However, consuming more than your own resources permit implicitly suggests luxuries have to be cut.
The current crisis is one in which governments are nibbling away at the luxuries, such that they never do enough to address the problems of their reliance on borrowed money. As I have many times argued in this blog, it is a vicious cycle in which the more a country borrows, the more more the economy is structured to consume the resources of the borrowing, and the more dependent the economy is on ongoing borrowing. Increasing the borrowing sees further restructuring of the economy to service the debt, and reduction in borrowing sees the elements of the economy that are unable to survive without the borrowing exposed to the light of day.
Then there is the positive feedback. The more borrowing in the economy, the more activity in the economy, the higher the GDP growth, and the greater the GDP growth, the greater the borrowing as the growth is taken to indicative of an ability to repay the borrowing. The greater the borrowing, the more the economy restructures to service the consumption that originates in the borrowing. And so it goes on.....and this is how we come to the current crisis.
And here is the rub. When I first started this blog, I argued that there is no justification for government borrowing in 'developed' economies, outside of calamity such as war and natural disaster. With major infrastructure in place, a large tax base, there is no need for borrowing, unless it is for politicians to give an illusion of greater wealth. All government functions should be financed from current revenue. Borrowing money is to buy luxuries now in order to bribe sectors of electorates with their own money; a cliched example, the early retirement age of Greek civil servants.
Government borrowing also has another impact. The more a government borrows, the less money is available for private investment, or the greater the cost of private investment. When governments compete for finance, they do so at a cost to investment in the private sector. Sure, the money nevertheless appears in the economy of the country, and stimulates investment, but this investment is directed towards servicing the consumption of the government's borrowing. It is the positive feedback system again. The money directs investment within the economy that can only be sustained by ongoing government borrowing.
As such, in the end, the only way to end the problems that have accumulated through the debt cycle is to implement real austerity. This means that an economy must shrink back to the point at which it can sustain itself with no government borrowing whatsoever. It means that the sectors of the economy that are reliant upon this borrowing must collapse back to the size they would be without borrowing. It will not be pretty. We are seeing the process taking place to some extent in Greece. If we imagine that a country like Greece was to literally halt borrowing overnight, we can imagine the impact upon the Greek economy. Within weeks, many functions of government would simply collapse through lack of money. Businesses would collapse as demand dramatically shrinks, unemployment would skyrocket, and government revenue would collapse.
For this reason, I do not propose an overnight change. What I do propose is a more demanding type of austerity; one which will enforce the end of borrowing by governments. When I say the end of borrowing by governments, I do not mean stabilisation of debt growth, but actually zero borrowing. There is absolutely no justification for government borrowing in principle. As I have argued, government borrowing is fundamentally problematic.
The current crisis in Europe is indicative that time is running out, and the only real solution is to accept the downward spiral, go through a few miserable and painful years, and then see an emergence from the mess. In order to do this, governments need to set a clear time frame for achieving zero borrowing. Within this frame, they must accept that, as they severely cut borrowing, their revenues will fall as unemployment rises and businesses collapse. In order to make the cuts that are necessary, they need to determine the nature of luxury and necessity.
A long time ago, as the economic crisis burst onto the world stage, I proposed reforms for the UK economy, which sought to find ways of trying to reduce government expenditure whilst, as far as possible, trying to protect the government services that I believed were necessities. For example, for benefits, I presented a system that provided a safety net but without the luxury of keeping large numbers of people unemployed over long periods. I do not propose this as an answer now, as it is perhaps too late for what, in the short term would be a high cost soution, even though it would make the system affordable in the long term. And this is the crux of the matter. Instead of acting to rectify problems, governments went on a borrowing spree to support a standard of living and consumption that was simply an illusion. In not acting earlier, this kind of reform is now a luxury that cannot be afforded, and the answer to government debt can only be more harsh, and more unforgiving.
We now come to the point where this less painful kind reform will not be allowed by creditors, who will just see short term cost, rather than the long term structural saving. For this sad state of affairs, whether Greece, Italy or the UK, we can blame our politicians, and we can blame ourselves for not asking the obvious question. Why do governments, with major infrastructure in place, and access to a tax base, borrow money?
As it is, each country that faces crisis will no doubt continue to nibble at the luxuries. As they do so, they will fail to address necessity versus luxury, and the crisis will continue as each nibble fails to achieve stability, and thereby forces a new nibble at yet another luxury. It is the way that Greece has gone, and the way ahead for the other overly indebted countries. Nibbling into oblivion.
Note: Apologies for some digressions in the post. I started the post in one direction, and then found the direction shifting towards another direction entirely. The end result is a bit too much of a ramble (again) but time does not allow me to start from scratch. Please feel free to comment on the underlying argument. I am aware that my ideas about government borrowing fly in the face of much what people seem to implicitly think, so critiques and comments are welcomed.