Thursday, May 17, 2012

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. 

9 comments:

  1. I am not sure I can agree with the sentiment behind the assertion that wage reductions could be disorderly whereas they should be orderly.

    I would be inclined to draw a distinction between reductions of pay in the private sector and those in the public sector.

    In the private sector they happen as each business tries to stay afloat and the result is that similar businesses in different parts of the country (and even in different towns in the same county) face financial pressures unique to that business and react accordingly. A 1% reduction might do the job at Swindon Widgets whereas Swindon Doodads requires a cut in its wage bill of 5%. Some might think that disorderly and it is certainly not uniform, I prefer to look at it as the result of the businesses each having to operate in its own little sphere and do the best it can to stay alive for the benefit of all its employees.

    The public sector is where the problem arises. The recently patently sensible proposal to pay different wages in different parts of the country was met with condemnation by the unions and their cheerleaders at the BBC. A hospital consultant in Yorkshire might be able to live in a five-bedroomed detached house when his equivalent on the same salary in London can afford a two-up-two-down in Clapham or Stoke Newington. It's nuts.

    To try to reduce public sector pay, in the circumstances that prevail at the moment, cannot be anything other than orderly because a high degree of uniformity would be required for political reasons. Indeed, that is what is happening with government-mandated pay restrictions in the few fields not affected by blank cheques written by the previous government.

    What I have said only applies to the UK, of course, I cannot comment on how these things might work abroad.

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  2. Hi Cynicus. Not commented for some weeks, but I'd just like to say that your last few posts have been really focussed and incisive. Thanks.

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  3. I'd forgotten how interesting your observations having not visited the site since you went on a sabbatical.

    Its been obvious for a long time that massive civil disorder leading to a complete breakdown in society would be necessary to break the link of money for nothing. Mutually agreed pay cuts and lowering of living standards would never be agreed to as it would be impossible to reduce equally across the board.

    Maybe a Greek implosion would be a good thing, not for the Greeks of course having to live the upheaval but for others walking a similar path, a visible example of what money for nothing leads to may be enough to start a reversal, although in all honesty I doubt it as I'm always concious of the some are more equal than others line.

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  4. So the core of the matter is that hard-nosed financiers, businessmen, politicians and pretty much everyone else, cannot tell the difference between debt-fuelled growth, and 'the real thing' (what you might call 'organic' growth?). Even now, when the wheels are falling off virtually no one understands the problem. If this is the case, then how could the free market ever be expected to work? Basically *all* actors within it are deluded or stupid or both.

    I know you think that it is the meddling of governments in the markets that has led us to where we are now, but belief in the predictability of 'the business cycle' and the inevitability of 'recovery' is so universal that one way or another, an unsustainable exponential boom was always going to happen, as long as resources were freely available, and a crash was always going to happen when competition for those resources hotted up.

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    1. You only have to look at the debt fuelled housing bubble to see that the Government didn't understand how it works or didn't care. House prices continually going up can only be good if inflation is driving them up or the economy is doing so well that excess money is put into houses. 100% mortgages do not suggest excess money and inflation was around 2% for a look time. Everyone knew the price increases were driven by borrowed money. Everyone wanted to get on the ladder before the prices were completely out of reach.
      The Government just sat and admired the GDP figures. They've also done everything to keep the prices from collapsing.

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  5. The May Committee July 1931 recommended pay cuts. the National Government imposed 10% cuts throughout the public sector and Armed Forces. September 1931 the Invergordon Mutiny flashed around the world and precipitated a run on Sterling

    http://en.wikipedia.org/wiki/Invergordon_Mutiny

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  6. I've always said that the collective economic experience of the West will be like an old established previously wealthy family who is living on past glories. Money was once made by wise and hard working men, and large estates and investments were purchased. And slowly over time the predations of the tax authorities, and the spending proclivities of younger generations conspire to gradually reduce the wealth of the family. Initially they continue their lifestyle by the gradual running down of the investments and selling off of property, and then by reducing expenditures (only one or two staff instead of a houseful, then eventually none). Occasionally they will get a boost by marrying some money (North sea oil?) but slowly and surely the level of wealth and standard of living declines. Finally the family house has to be sold and all of the hard work of previous generations is undone. Our last of the line grandee is reduced to penury, living in a bedsit somewhere, telling whoever will listen that he 'used to be someone you know!'.

    That is our collective future as far as I can see. The experience is likely to be more traumatic for us, as the ability of politicians to borrow on behalf of a nation of people far outweighs that of an individual family. Thus it is possible to continue much further down the 'we think we are richer than we really are' path collectively than as individuals. And the distance to fall from imagined wealth to reality is commensurately further. Individuals and families slide relatively gracefully into poverty, nations crash into it.

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  7. "large estates and investments were purchased."

    Large estates were the problem. Industry was run to make families landed aristocrats buying titles and the minute Britain faced competition from Germany and USA 1870s it slid into a 23 year Depression and Revival only came through two World Wars stimulating domestic trade by destroying the wealth of the nation. Prior to 1914 British exports were mainly cotton and coal yet it had a huge overseas portfolio yielding £5 bn annually.

    It nevertheless lagged France in developing automobiles and aircraft engines. Rolls-Royce only entered aircraft engine production because the Government ordered it to and supplied a Renault engine to copy and W. O. Bentley furnished a Daimler engine. The British car sector then developed as speculative IPO fodder akin to dot.com and was regarded as risky so that Canadians like Max Beaverbrook emerged as a large stakeholder in Rolls-Royce who wanted to move it to Canada.

    Britain did not recently go off the rails, it has a cultural bias towards trading assets rather than creating them and living high on the hog to go Clogs to Clogs in 3 Generations. Both World Wars were acts of sheer stupidity with no gain and simply handed over British overseas portfolios cheaply to the USA. We even paid Krupp 3d/fuse licence fee for shells and had to create ICI by Government fiat so we did not need to import dyestuffs and explosives from I G Farben.

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    1. A Real Black PersonMay 27, 2012 at 10:02 PM

      Britain, the first country that industrialized in Europe, created a modern empire under the guise of free trade.
      Empires by their nature are parasitic, because while they expand the scope and quantity of trade, empires are created to benefit the people from the Mother Country, not people from the conquered lands. The Mother Country takes more than it receives in order to make maintaining the empire worthwhile. In a market economy, something that most countries participate in now, this creates problems because trade deficits can only be maintained with military aggression or debt. Even countries that have a positive trade balance, often become dependent on resources (petroleum, minerals) and labor (outsourcing) from abroad. It doesn't matter if a country exports more in monetary terms than it inports(statistics such as 8 billion Euros worth of goods in exports vs 3 billion Euros worth of goods in imports are meaningless in determining whether a country is living within its means), it is likely that it is importing more material than than it is exporting. A country that relies on imports can support a population larger than it could before it started importing and it can afford higher living standards because more resources are entering the country then are leaving. Most of the problems with governemnt debts in developed countries have to do with the historical sense of entitlement to a greater share of the world's resources no doubt fueled by the economic legacies of unequal trade from colonial empires. In the U.S., where I live, there is too much frevor around whether a country chooses to sell oil to the U.S. or not. Cynicus says too many sectors in the modern developed economy in many indebted countries are structured around borrowed money. I say that they are structured too much around imports.

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