Is Extend and Pretend Coming to an End?

I can't remember where I first saw the phrase 'extend and pretend' (so apologies to the originator for not citing them), but it is a good expression to the reaction to the economic crisis. Another good one is 'kicking the can down the road'. Both expressions concern the endless (and often hidden) bank bailouts, the fiscal stimuli and the monetary policy that has been the reaction to the economic crisis. What they have been attempting to bury with their policy levers is debt. Or rather, debt that is not going to be repaid. Consumer debt accumulated in the build up to the crisis, sovereign debt built up in the aftermath (and to some degree in some states before the crisis). Tied in with the rise in debt, was the rise in asset prices, as floods of borrowed money created booms.

In Europe, to add another metaphor to the many, the wheels look like they may be about to fall off the Euro bus. Yet another metaphor is contagion, but (as I mentioned before) a better metaphor is that the financial doctors have become better at diagnosis. It is not a contagious disease that is hitting Europe, but the cancer of debt fuelled consumption. We had a bust back in the days of Lehman's and, instead of taking the pain at the time, the reaction was to extend and pretend. Whatever happened, intoned our policy gurus, we must not repeat the Great Depression. And, with the magic of their policy levers, that is what they claim to have done. Avoided another Great Depression. The European Central Bank has thrown everything but the kitchen sink at the Euro crisis. The IMF and the EU, and even the Federal Reserve, have bailed out, and the bailees have to varying degrees tried to reduce their consumption.

If only we had not imposed 'austerity' is the cry of many. But who was going to continue to fund the borrow and spend policies? In Europe, the only taker stepping up was the ECB, who lent money to insolvent banks so that they could buy the debt of their insolvent governments. You may note here that there is something very wrong with the concept of austerity; it still includes huge amounts of borrowing by governments. No country is stopping their borrowing, they are just trying to decrease their rate of borrowing. That borrowing is going to support ongoing unaffordable consumption. In the meantime, the background is one of accumulation of mountains of debt.

Alongside the attempt to reduce the rate of borrowing, there has been shrinkage in many economies. As the economy shrinks, so does the ability to service the existing debt. It is not, as the growing legions of anti-austerity commentators claim, that austerity is causing the crisis. Their answer is to return to growth in the rate of debt accumulation in order to hide, for a little longer at least, the underlying fundamental problem. Many countries are consuming more than they produce, and have no real prospects of being able to pay back the money they have borrowed to over-consume, or to continue to live at the level they have become used to. They are, to quote my first ever post, poorer than they think. They mistook debt for wealth, and must now learn to live based on their own productive output.

The only real step that can solve the European crisis is to just stop borrowing. Alongside this, there needs to be a recognition that many countries have, in the most basic terms, an unaffordable lifestyle. It is very simple. They must accept that they are poorer than they think. In order to return to stability, that relative poverty must be accepted. In crude terms, over the economy as a whole, the borrowed and consumed money is the equivalent of adding to the salary of every individual within that economy. As the borrowed money flows through the economy, it is adding unaffordable goods and services for consumption. The borrowed money indirectly subsidises consumption, and in some cases does so directly.

The solution is simple, and always has been. Stop borrowing money. The Greeks complain of Germany forcing them into austerity by diktat. However, Germany is not forcing any country into anything. It is saying that, if you wish to continue to borrow, you must do something to ensure that you can repay the money. If Greece wishes to restore its sovereignty, the answer is to stop borrowing. It really is that simple.

However, in Greece, and in so many countries, there is a reluctance to accept this. The standard of living that they have enjoyed on borrowed money is seen as a right. Civil servants protest, unions protest, and anti-austerity leaders demand the lifestyle that the country cannot afford. They all demand the status quo of pre-crisis borrow and consume, but just do not accept that the lenders are no longer there. They are all demanding the impossible, and their populations believe that the impossible is possible. We can see how seductive the calls for greater borrowing and spending are. If you are a civil servant thrown out of work, and you have a mortgage and family to support, it just seems unfair.

However, when faced with pay cuts, the same civil servants will protest, even though their collective salaries are unaffordable. The same with the workers throughout the economy. They simply are not, collectively, productive enough to support their lifestyle. The answer is unpalatable. It is cuts in wages and benefits to the point where the economy as a whole returns to competitiveness. How these are spread over the economy is an issue of politics, but the reality is that this is the only answer. The reality is that, for all but the most productive economies, the price of labour must fall. There is a glut of labour in the world, and this is resultant from the emergence of the emerging economies. Unless labour is exceptionally productive, there is no other way out.

If we take the example of Germany and Spain, German workers and Spanish workers are in direct and indirect competition with one another. German workers are, in aggregate, more productive than their Spanish counterparts, but this is not reflected in the costs of workers. If it were, then Spain would be able to balance their trade with Germany. There are no trade barriers, and we have to just conclude that, in aggregate, Spain's companies cannot compete with those of Germany. I am not just talking about wages here, but the overall structure and cost of the economy as a whole. This is why I included benefits in my earlier point. The many benefits provided by governments are an indirect cost of labour. The cost of labour in the economy is a critical factor in competitiveness. It is the productivity of the collective output of the economy in relation to competing economies.

These underlying differences in the real productivity and competitiveness of economies were both obscured by debt accumulation. They can continue to be obscured by debt accumulation, but this simply prolongs the moment when reality must finally emerge. At this stage, we cannot know whether the ECB, EU or IMF might just pull some new lever to extend and pretend a little longer. However, it is starting to look like extend and pretend has reached the limits. It is starting to look like there is no road left to kick the can down. The cuts in wages and benefits looks to be the next step. This process looks likely to be disorderly, and that is the real pity. It could have been gradual, controlled, and less painful. The way it will take place, the degree of pain, can be laid directly at the door of extend and pretend.