The Multilplier Effect of Borrowing and Economic Structure

This was originally part of a larger post, but I decided to edit it down to a single point, and will probably chop the remainder of the post up later. As such, it is not up to date on the latest news, but the news on which it is based I think is not the stuff of 'events', but rather reveals something which is driving current problems in Europe and many other countries are facing.This is from the article that started the post:

“This week the socialist government in France went berserk with austerity and tightening measures. This could put the country’s recovery at serious risk and perhaps President François Hollande may need to re-read the economic page on ‘fiscal multipliers’ – if no book is available the S&P Rating Services offers a sanguine view on page 5. The study proves how the fiscal multiplier in Spain has been closer to 6 to 1, rather than 1 to 0.5% rule which IMF applies. In the case of France we have an economy with low rates, an expensive labour market and now a new marginal tax of 75% - everything being equal will that lead to lower or higher growth?  I think you know the answer, even without 5 years wasted at a university becoming an economist.” Steen Jakobsen, Chief Economist at Saxo

There is a link in the quote to an a report from S&P, which gives a breakdown of fiscal multipliers; 'For instance, in the UK, a fiscal contraction equivalent to about 4% of GDP between 2009 and 2011 had a negative effect on GDP growth about twice as high as the typical fiscal multiplier implies.' (p.5) The reason given in the S&P report for the higher multiplier is that there has been a simultaneous fiscal tightening over the developed world, and that the effects of reflationary policies in countries like China are fading. 

There are two interesting points that emerge from the S&P report. The first point is that they are actually identifying how critical government borrow and spend is in supporting many developed world economies. The ever well-informed but ever more dubious analysis of Ambrose Evans-Pritchard leads to this conclusion being drawn from the report:

Europe's manic determination to tighten further into recession to meet its bureaucratic targets is nothing less than suicidal.

However, the real point that can be understood from the report is that it reveals something of the depth of the economic structure that is being supported by government borrow and spend policy. Regular readers will know that I have often expressed concern about the way in which many countries have structures that have developed to service debt driven consumption. The interesting thing about this report is that it starts to hint at the degree to which economies are now reliant on ongoing government borrowing to maintain current standards of living. In my first ever post, I argued that, for example, the UK is poorer than it thinks, and this is the case in all of the countries that are following the borrow and spend path through the economic crisis.

It is not at all complicated. Current standards of living are to a very large degree contingent on borrowing and consuming. Economies that do so are simply entrenching the structure to service consumption based upon growing debt. As soon, as a government cuts back on debt growth, the structure that is supported by debt growth starts to collapse, and the real wealth generating economy underneath the unsustainable structure becomes exposed. Quite simply, there is no way out of the pain of restructuring, unless there is major economic upturn around the world. The problem is that, as the situation stands, this is not going to happen.

The Keynesians argue that the answer is more fiscal stimulus, and that this will regenerate demand, and all boats will rise with the fiscal stimuli. If only everyone borrowed and spent, all would be well. However, there is a fundamental problem with this idea. The more countries borrow, the more they restructure their economies around the borrowing. If, as they Keynesians had their way, all the countries of Europe were to raise their borrow and spend, this would (assuming that creditors would go along with it; a big assumption) lift Europe out of its current funk. The problem is that the restructuring of all economies to servicing debt based consumption would simply be greater. As country A borrows more, it would not only lift country A, but also countries B and C, which would help service the new demands in country A. The new activity in country B would also lift demand in country A amd B, and so forth.

The problem with this solution is that it is simply spreading the underlying structure of debt based consumption more broadly. Instead of just being reliant on your own borrowing to support your current standard of living, you become reliant upon country A, C, D, E etc. also continuing to borrow and consume. It merely extends the reliance of borrow and spend into an ever more entrenched network. As soon as any country in the network stops borrowing and spending, it impacts upon other countries within the network. Just as the upwards multiplier in the above paragraph lifted all boat, the same can be said of the downwards multiplier. It is this downwards multiplier that the Keynesians fear, and they are right to fear it.

The Keynesian's problem is that they simply do not accept that the more governments borrow and spend, the more entrenched the underlying problem becomes. The greater the coordination in borrow and spend, the greater the network effect of the multiplier, and the greater the negative impact when any single borrower cuts back. In the case of Europe, the fate of each economy is closely entwined with the European economy as a whole due to dense trade links. Any increase in borrowing of any country will improve the economy of its neighbours, and thus make those neighbours more reliant upon continued borrowing. The problem is that borrowing must have a limit. And as each borrow and spend domino falls, the others start to wobble as the effects of the falling domino moves through the network, multiplying the effects beyond the original domino. Coordinated borrow and spend is metaphorically moving the dominoes ever closer together.

The other problem is also distantly related to game theory. If country A tightens whilst all other countries increase borrow and spend, country A will start to restructure its own economy to be less reliant on borrowing. The stimuli from other countries will help it through the adjustment, and it will be left in a position of relatively less debt. It will still be reliant upon the network effect of the debt accumulation of the other countries in the network, which still means further pain at some point in the future, but the pain will be less than those who borrowed most profligately. By contrast, the country that borrows the most will undergo the greatest restructuring to service debt, and will contribute most to the network, at a cost of being in a weaker position in the future. Whilst this debt accumulation will maintain (or even enhance) their own standard of living in the near term, they are also disproportionately contributing to the network at a cost of increasing their debt and greater cost in the medium to long term. In other words, the smart policy now is to restructure whilst encouraging others to borrow and spend; as long as you are not the lender to those borrowing and spending, as these countries are going to have the greatest problems in repaying the debt later.

When looking at the fiscal multipliers, it is possible to see something of quite how large the debt consumption structure actually is for each country, but what is does not show is how those multipliers might effect a dense network. The problem is that we know that individual country multipliers will certainly have network multipliers, but nobody can calculate the network multipliers, which would require understanding of a dense network of interlinking relationships and layer upon layer of feedback between actors in the network. The real complexity in the European network is the different starting points of different countries, and that apparently less debt structured countries have already been lending heavily to those that have been net contributors to the system, not realising how dependent they themselves were becoming upon debt based consumption. Without this, we would see a very different response to the crisis. 

What this finally comes to is that government borrowing to support consumption cannot be sustained. Borrowing must have a limit. Although cut backs in borrowing will result in a downward spiral, and the downward spiral will be large if there is simultaneous cuts in borrowing, this does not alter the fact that, at some point, economies must restructure. Coordinated borrow and spend can only make the problems even larger in the future. Acting as a net contributor in the network is foolhardy. Lending to a net contributor is foolhardy. Notwithstanding the complexity engendered by past lending, it leaves Europe in a position where the only real solution is to accept that the restructuring will lead to a downwards spiral. Better now than later.

Notes on Comments on the Last Post:

Lord Sidcup:  I agree that, in some respects, the dichotomy between real and unreal becomes ever harder to see. I am very sympathetic to the creditism argument, and the original version of this post was going to address what is 'real' to some degree. For the moment, I will just say that what we are seeing is not that there is not a real underlying economic reality, it is just getting harder and harder to see. In some respects, it is a flight of fancy to use the world 'real', but what I mean by this is the idea that economies, in the long run, are comprised of individual actors who buy and consume 'stuff' and create 'stuff'. The global economy still comprises this fundamental structure. The relationships between these actors are the fundamental drivers of economics in the long run.

These actors operate in a global system comprised of the other actors, and there are subsystems in which these actors participate, which is individual country economies, and these operate more or less efficiently. These in turn have economic entities which operate more or less efficiently. Beneath this is the layer of individual actors, who also are more or less efficient. Obscuring this is money and debt (I will not argue about the distinction between these here), which is a layer over the top of a system in which each individual actor is a consumer of resources and/or adding value to resources (not all actors are both consumers and 'value adders') within a system.

The fundamental of 'real' wealth creation is the efficiency with which value is added to any given resource, relative to other actors. If you can take an input and add more value to it than another actor, then in the long run you will be more wealthy. The obscuring layers hide where the real value is being created. I know this is an incomplete answer, but I hope it helps to clarify a little about what I mean by real. However, in some respects I accept what you say about a false dichotomy, as the unreal and the real are ever less separable.

Lemming: An interesting point about throwing the dice on infrastructure:

He doesn't say it as such, but I think there's a suggestion that if we borrow lots of money to build infrastructure and then default, at least we'll have the infrastructure; if we don't do that, we'll still default because we won't be able to grow, and we won't have the infrastructure for the future either.

I did not see Evan Davies, but note your mention of 'investment' in infrastructure for new rail lines. These were no doubt called an investment, but rail requires subsidy. As such, it is an investment almost guaranteed to create a negative return in financial terms. However, it might have a positive return in improving 'quality of life', but that is achieved at a cost that needs to be considered against other priorities for government spending.

However, the problem runs deeper than this example. If it is accepted that government should provide and invest in infratructure such as roads (which is another topic), then it is quite right that investing in infrastructure might be viewed as a positive, provided that there is a real need (and in the case of roads I would think that this is probably the case). However, the problem of the UK is not one caused by investment in infrastructure, but rather that there is overall consumption that exceeds the wealth generating capacity of the country. The question then becomes one in which it is necessary to ask what can be afforded. Provided that there is a real need for x infrastructure project, it absolutely should be at the top of the priorities. The problem is that nobody is willing to really accept that there must be much tougher priorities or the resources available to goverment must be used more efficiently.

In other words, asking for greater investment in infrastructure may be reasonable, but still leaves the problem that the current undertakings of the government cannot be afforded in their current form. The assumption is that the spending on infrastructure must be undertaken on top of the current undertakings. Where does the assumption come from? It is quite possible to cut undertaking x and y, and at the same time put resource into infrastructure. They are not mutually exclusive. And if, and it is a big if, the infrastructure improves the economy, this will allow for greater resource for the government in the future. My real worry in all of this was that, in particular during the build up to the crisis, was that the words spend and investment became interchangeable. However, that again is another topic. The main point here is to point out the problematic assumption. There is no reason that spending on infrastructure should mean incresing borrowing.  It is just a question of priorities.

General Comments: Thanks for the positive feedback. Also, some challenges and interesting contributions. I would love to answer all the comments, but as you can see, this is already a long post with some long answers to a couple of the comments already. Quite simply, I have run out of time.

Final Note: For some reason, the Blogger service keeps changing 'S&P' to gobbledygook - apologies if this takes place when I hit the publish button, but I am unsure how to fix it (and it may happen in this note as well).

A reply to a comment on this post (same day as post, the reply was too many characters for the comments so added here):

Nice to see you commenting again Chaingangcharlie. I agree that the lead up to the crisis was not a very positive picture for the invisible hand but.....  but the sudden dropping of massive surplus of labour into the world economy was not the work of the invisible hand, but very visible hands. China and India kept their workforce out of the global supply, and then 'dropped' their workforce into the supply. The invisible hand was not the cause here. As a regular reader, I am sure that you will know my argument that this labour shock was the underlying cause of the financial crisis (aided by regulation), the boom in credit etc. I cannot detail this here. However, the point is that it is not the visible hand.

As for bankrupt, you are right that printing money is not going bankrupt in the strictest terms. However, if you hold a devalued GBP that has taken a 'haircut' as a result of devaluation, how is this different from taking a haircut more directly from a failure to pay and renegotiation?

In both cases, the value of your bond holding has fallen, and the issuer has failed to pay what they implicitly promised; returning to you x% of greater value that you lent. A country cannot be legally bankrupt, but being unable to pay your debts is, from a pragmatic point of view the same thing. 

As for the market knows best, as I have detailed in other posts, the global economy is no longer about market signals, but about government and central bank actions. Again, there are very visible hands at work, and how is that working out for us? You say we will head into a long period of pain, and suggest this is not the answer. However, we can see what has happened when the other answer has been pursued to a conclusion; Greece and Spain.  When it comes to other borrow and spend countries, they may have a while yet, but......what must finally happen unless they eventually accept that they cannot consume more than they produce....?

You have confidence, it seems in the policy makers who failed to see the crisis coming, who have not resolved the crisis since it became apparent in 2008, and who have in the meantime printed and borrowed to no effect. And despite this policy action, as I have discussed before, people are still getting poorer, and doing so whilst racking up future commitments that will make people even poorer.

In the meantime they have obliterated any functioning of the market, created monetary time-bombs, and borrowed to the point where any prospect of repaying the debt grows ever more dim. In so doing, what have they created; an economic system that is now policy driven. But driving where? Do you see this policy action working on any level at all, except for building and ever less sustainable and distorted structure?

You have faith in policy makers to make things right. I have no faith in them whatsoever, as their record is dismal. They have failed on every level, and even the most casual reading of the news shows that this is the case. Even when the news is positive, the situation always reverses. The overused phrase of 'green shoots' appears, only to see that there were no real green shoots, or that the shoots whither as soon as they emerge. How much failed policy would it take to convince you? What would it take to dissuade you of the necessity to change course?

Unlike those who proposed exansionary austerity, I never bought this idea. I always recognised that you cannot restructure away from debt fuelled and unsustainable consumption without a painful adjustment. And this is why I emphasise that the problems are that economies are structured around debt based consumption. If that is accepted, then more debt just deepens the problem. More countries simultaneously increasing debt just raises the problem to a new level and deepens the structural problems. I understand your concern, but surely leaving the current system in place can only eventually make things worse.

And then what will the final mess look like? I do not like the choice I propose but it is the same point I have made for a long time; pain now or more pain later. I go for pain now. It is not good, it should never have got to this situation etc. etc. but the situation as it stands is still the situation.

The Pause in Quantitative Easing

Finally, the Bank of England has ended the policy of Quantitative Easing (QE), albeit that they are describing it as a pause:

The Committee will continue to monitor the appropriate scale of the asset purchase programme and further purchases would be made should the outlook warrant them.

The weasel worded technical name has never hidden the underlying reality of QE; that it is identical to the running of a physical printing press to print money. The vast majority of that money has gone into the purchase of government debt, and the cumulative purchases have been enough to have funded much of the unprecedented peacetime debt racked up by the government:

The amount spent by the Bank of England on its asset-buying program since March is almost 89 percent of the 225.1 billion pounds of bond sales planned by the Debt Management Office for the current fiscal year.

The fig leaf used to justify QE was the prospect of CPI deflation, and with CPI inflation moving higher, the initial justification for QE has disappeared. The bank must now leave the UK government to sell its debt to private investors and overseas central banks. The timing of the ending of QE has both positives and negatives.

On the positive side, there is a looming general election, and the possibility of a new government that might make real cuts to the size of the government deficit. The Conservative Party still looks the likely winner of the election, and have expressed greater concern about the deficit than the Labour Party, but still with no real concrete plans for tackling the monumental scale of the deficit. Despite this, some investors might suspect that, fearing electoral damage, the Conservatives are hiding the scale of the cuts that they will undertake. The success of the issuance of government debt may well hinge upon such a weak foundation for some time yet, but the fragility of such a foundation leaves a very real possibility of a failed debt auction. Then there is the point that the Bank of England has not ruled out restarting the printing presses, which analysts believe has weighed down on the £GB.

The concerns over sovereign debt extends further, with the ongoing saga of the PIGS (Portugal, Italy, Greece and Spain):

The Spanish and Portuguese markets led the declines as investors' fears focused on whether government plans to cut their deficits are tough enough. By late afternoon, Spain's main market, the IBEX, was down more than 5pc and Portugal's benchmark, the PSI-20, was off a similar amount.

The prospect of a sovereign debt crisis has been seen as one of the biggest risks facing the global economy this year as the downturn catches up with heavily indebted countries. Attention so far this year has been on embattled Greece, where the Government's debts have jumped to 12.7pc of gross domestic product, but appear to be switching to Spain and Portugal.

Then there is also increasing concern over the size of the US deficit, with many analysts and commentators worried about a sea of red ink stretching out to the horizon. Obama's freezing of sections of spending has done nothing to dent the fears that the US deficit is unsustainable, as the freeze covers such a small portion of total expenditure. Obama's expressions of concern over the deficit mean nothing if action does not follow the words. The result is the prospect of a downgrade of US debt:

The credit ratings agency cautioned that if the US were to grow at slower pace levels than expected, the largest economy in the world’s already-extended finances could be over-stretched, in turn damaging its AAA credit rating.

This might again be seen as a positive for the UK, but the position of the ratings agencies on the UK is equally as concerned, and preceded the worries about the US. Moreover, this is a comparison of a bad situation with a bad situation, and does not detract from the underlying reality that both countries are looking increasingly risky places to invest money. It is a bit like comparing a man with broken arms and a man with broken legs, and trying to decide who is in the worse situation.

Whether the US, the UK, or the PIGS, there is a concern that there is no solution to what is becoming apparent as structural long term deficits. It is not the deficit today that is the major problem (though that problem is large enough), but the lack of any route out of the deficit spending. In fact, ballooning entitlements from demographic changes present the prospect of enlargement of deficits, and further declines in the tax base.

The solution to the problem that is proposed by governments is that they must ensure that their economies return to growth. When they say growth, they actually mean debt based growth, meaning replicating the ersatz growth that took place before the economic crisis. There is much lofty talk of the resuscitation of growth through new technology, and innovation, but it all sounds like the much vaunted service economy, or post-industrial economy, touted before the crisis hit. Whilst talking of the innovative and growing economy, the governments are simply spending and consuming the future wealth of their countries. As I showed in my last post on the US and UK, the increasing deficits being generated by governments a just a return to pre-crisis levels of consuming more in relation to what is produced.

When looking at sovereign debt, there are risks in every direction. Some analysts argue that Japan is looking high risk, others that the PIGS are ready to topple, and so forth. We can see the volatility and uncertainty in the currency markets, with endless shifting tides on each piece of data from each major economy and each policy response. It is now becoming a waiting game to see which economy will topple first, and set off a domino reaction around the world. In this context, is the UK at greater or lesser risk with the pause in the policy of QE?

There are many factors at play, which is the relative risk of UK debt in relation to other countries, as well as confidence in the overall economy. The UK does have a trump card in the forthcoming election, and the pause in QE may be seen as a positive. An alternative view is that the end of QE will now hasten a failed bond auction, and thus prompt the crisis. However, even if the UK does not lead a crisis, will a contagion from, for example the PIGS, just mean that the UK becomes a follower rather than just a leader? The UK is looking very vulnerable, and therefore is at great risk of contagion. This from Edmund Conway of the Telegraph:

Greece, in other words, is the fiscal Petri dish that reveals in gory detail what could happen in the UK if this Government – or the next – fails to maintain the confidence of investors. It is not merely that those interest rates are already inflicting an awful toll on borrowers in Athens and beyond. It is that they are sending the national government towards a full-blown debt spiral, in which the cost of its annual interest bill becomes so unmanageable that it can hardly afford to supply its citizens with basic services.

I take Edmund Conway's analysis with a very large pinch of salt but, in this case, his analysis is reasonable. Unsustainable borrowing will lead to problems, one way or another. The difference between the two countries is the UK can print its own money, but that of itself does not alter the need to eventually live within your means. It only serves to translate the nature and timing of the crisis (with potential for greater damage). However, will the Bank of England really end QE, or will the prospect of a failed bond auction see the Bank of England cave in, rather than see the crisis that follows such an event?

Perhaps the most curious aspect of the looming risk of sovereign debt crises is that, even as we read of them, we hear talk of economic recovery - albeit with many caveats. One of those caveats that is often mentioned is that governments can not sustain massive deficit spending forever. The problem is this; the 'economic recovery' is not a recovery but a rerun of debt induced growth, and the debt that is producing the growth is the driver of the potential sovereign debt crises.

If governments actually act to reduce their deficits, the so called 'economic growth' will disappear, and with it the confidence that the economies might service their existing debts. Their economies will contract rapidly, and with the contraction the debt to GDP ratios will soar and their currencies plunge. With the plunging of the currency, there will be the onset of rapid inflation, and loss of confidence by overseas creditors. For example, in a previous post, I estimated that, if just the overseas portion of US borrowing were to stop, the economy would contract by about 17%. That is just the impact of the end of overseas borrowing.

In this context, the US and UK policy of QE becomes clearer. Governments are on a debt treadmill - damned if they do, and damned if they do not. However, QE does not alter the underlying reality that an economy is consuming more than it produces, it simply alters the scope and nature of the crisis. It is a last gamble that something will turn up in the meantime to save the economies from the real underlying crisis. If all else fails, printing money to stave off a crisis in government funding looks more attractive to policy makers than the alternative being faced by Greece, on whom austerity measures are being enforced. The discontent within Greece has already started.

The reality is that Greece must now learn to live within its means. This is the reality that is being avoided with QE. Greece can not devalue, can not print money, and must actually accept that it is poorer than it would like to imagine. It literally means a lower standard of living than they have come to expect. In this context, I have to wonder just how permanent the pause in QE in the UK will actually be.

Note:

I read the interesting debate on the last post. I did however note some comments that were an attack on the person, rather than on their beliefs/views. I would prefer to see the issues debated, rather than the person, and generally think that the high standard of debate and thought (that contributes so much to the blog) would be better served by this approach. Many thanks, as ever for the links and contributions. I would like to respond to some of the points, but seem to have less and less time to do so, but will try to do so.