The Perpetual Economic Growth Machine

When first starting this blog, I had a thesis; that debt growth was the underlying cause of 'economic growth'. As the blog progressed, along with the breadth and depth of my analysis, I came up with the idea that the economic crisis had an underlying cause; a labour supply shock in conjunction with a lack of commensurate increase in commodity supply. It was an idea that I then used to develop the idea of hyper-competition. In light of this theory, I thought that the outcome would be clear. The Western economies were uncompetitive, and they would lose out in the face of the competition from the emerging economies. It seemed so screamingly obvious that I wrote a post in 2009, predicting that it was the year of the fall of the West (Japan was counted in the West, which I know is a little odd). It was a post in which I made a poor assumption; I thought that, one way or another, the underlying and obvious problems of the Western economies MUST be recognised.

The crash I predicted failed to take place, and I took a hit to my credibility.

When the predicted crash failed to materialise, I was heavily criticised by commentators on Reddit. I responded by saying that at least I was willing to put a date on the turning point, whilst others lack confidence in their theories and refuse to predict outcomes. I should have added that a theory needs to be tested by evidence; can it predict? If it cannot predict, then it fails. Most of what you read does not offer the confidence to predict outcomes, or leaves the timings of outcomes open. The authors shroud their thesis in ambiguity, and nothing they say can be held accountable.

My mistake at the time I wrote of the Downfall of the West was that I failed to see that there was plenty of extremes to which policy makers were willing to resort. In addition, I failed to see how entrenched views of the world were; the West was the heartbeat of the world economy, and NOTHING would ever change that. It a question of government action acting to support and shore up a world view that is resilient the the underlying facts. We would return to the status quo of the West living high on the hog, whilst those poor countries tried to catch up. The world economy would return to the natural order, once we just sorted out the fallout from the 'financial crisis'. It was just a problem in the financial system, and some policy action here and there would return all back to 'normal'.

If you have contrary evidence to your theory, you need to ask why you got it wrong. Perhaps, in the explanation I have given above, I am making excuses. I am highly self-critical, and do not believe these are excuses. In fact, as time has progressed, I have come to the view that I was right all along. Not right that there would be a terrific crash, but right in my underlying thesis. I expected drama, not the steady and relentless decline that has taken place. I argued that the West is 'poorer than we think' and we are steadily recognising this in the decline of the standard of living in many Western countries. We are slowly but surely seeing the middle classes being hollowed out, declining real incomes, growing unemployment (or underemployment). This is taking place against the backdrop of crazy levels of sovereign borrowing, money printing, and the related issue of extraordinarily low interest rates. None of this extreme policy seems able to lift the economies of the West.

Instead, whilst governments rack up debts, and money is pouring forth from central banks, we are just getting poorer. I have to emphasise the point that governments are creating mountains of debt, and we are still in day-to-day terms, getting poorer. We are already poorer, but how much poorer will we be when (assuming we actually pay it) we start to bear the load of the debt being accumulated now. Tax must rise at some stage to pay for it. The opposite view is that economies will return to major growth, and this will cover the debts. It is a promise that has been made for a long time. However, even as governments borrow, as money is printed, there is no real growth. There is only the anaemic growth that is following profligate borrow and spend policy.

It has never been complicated. If I borrow money, and use that money to pay for consumption, it generates activity in the economy. The borrowed money circulating through the economy creates activity, and that reflects in the GDP figures. Take away the borrowing, and GDP falls. We see this in Greece and Spain, and start to see what takes place when an economy reliant on borrowing stops borrowing. The evidence is there in plain sight. Nevertheless, there are many who argue that the problems of overly in-debt countries is to borrow more, and they convince many people. Borrow 1 billion, and it will produce 3 billion of activity in the economy, and the tax income from that activity will allow the economic growth to pay back the debt through increased tax revenue.

Just think about this. A country borrows money to produce revenue to pay back the borrowing. The problem is simple; resources are being consumed along the way. The view that borrowing more is going to solve problems is based upon the idea of a perpetual motion machine. There is no loss of energy, or in this case no loss through the consumption of resource. Borrow and spend is a perpetual motion machine. Borrowed money comes in, generates revenue to pay back the borrowing, and revenue then pays the borrowing. Nothing is lost. No resource is consumed. It is the perfect system. Except that it is impossible.

The perpetual borrow and spend, create revenue, repay borrowing machine is a truly unique idea. It is unique in that so many people have persuaded themselves of its possibility. We laugh at the perpetual motion machine, but many view this perpetual economic growth machine as possible. No loss. Just gain. Here is how it can work. Every year, we can increase our borrowing, and increase the activity in the economy. As the activity increases, we can increase our revenue, and that increases our ability to service our debts. In fact, we are not borrowing enough. If we accelerate our borrowing, we will increase our revenue, and we will be in an even better position to repay our borrowing. The more you borrow, the better you are able to pay back the borrowing. No loss, just growth in revenue, as nothing is apparently being consumed in the process.

If only the perpetual economic machine were true. We could forget having to compete and just borrow our way to prosperity.

I now return to my failed prediction of the 'downfall of the West'. We are growing poorer. And we are consuming based upon growing debt. Real resource is being consumed through debt accumulation. All would be good if there were a perpetual economic growth machine, but it is a fantasy. Nevertheless, that fantasy has real currency in the real world. It has prevented a crash, but we are nevertheless getting poorer. My error of thought was to believe that illogic would be uncovered. Instead, debate and discussion takes place, and the perpetual economic machine is the winning argument that drives belief.  Policy will make the economies of the West return to their natural and rightful position. If in doubt, just keep borrowing towards wealth.

The exceptions, the Spain and Portugal examples, just need to abandon austerity, and they will return to growth. The perpetual economic growth machine will deliver. It WILL deliver, because it MUST deliver. It is a costless machine. Nothing is consumed.

Update just after publication: Just a little note as I left my  thread of thought behind as I wrote (yet again). I missed making a key point. How could anyone predict that people might believe in a perpetual economic growth machine? But people do..... this was a crucial fault in my prediction. Sorry, but I was distracted from the point I was trying to make. I could not accept that the perpetual economic growth machine could be a foundation of belief, and the belief therefore might avoid the crash which I predicted. What we are looking at in the world economy is the contradiction between the perpetual economic growth machine as a belief, and the reality that it cannot and does not work (barring the exceptions such as Spain where we can see the idea collapsing). Reality and belief are bumping together, and reality is slowly winning out.

2nd Update just after publication: Long term readers will have seen my prediction, but still come back. I have always left it in place as I think my record of what I have got wrong is as important as what I have been right about (notwithstanding that I argue here that I was not so wrong). I do not believe that bloggers should 'airbrush' their record, and have left all of my posts as live.  I encourage new readers to dig into the archives. See where I have been right and wrong. Make a judgement on  whether I have something interesting to say based upon my record. I am obviously biased, but I think my record overall puts me in a strong position.....despite my admission/s that I have got things wrong (there is one case where I presented a detailed analysis of an economic forum, only to have an astute reader point out that I was a year out of date; I was analysing the meeting and output of the previsous year, but the post and apology is still online).

Has Anything Changed?

I it now seems a long time since the Lehman crisis revealed the underlying problems in the world economy. The post title asks the question of whether anything has changed since that time; the obvious answer is that, yes, there have been changes. The situation has been revealed to be very poor indeed. The response is even poorer. Unlike most of my posts, this will probably be relatively free of links and references. I thought it might be a good time for an overview.

The response to the Lehman crisis, and the financial crisis that surrounding the collapse of Lehman's, was to dismiss the problem as being a problem in the banking sector. The name for the problem became 'financial crisis', rather than the more appropriate 'economic crisi's. As I have argued elsewhere in the blog, the nature of the world economy had shifted; the joining of countries such as China and India into the world economy joined a massive supply of labour into the world economy, and effectively flooded the world with new labour capacity that could not be readily absorbed. In particular, the 'emergence' of these economies was infrastructure intensive, and they presented new demands on the supply of the basic commodities that sit underneath economic growth. Whilst the supply of commodities have expanded, the supply is continually being stretched to meet ongoing increases in demand (with the ups and downs of the Western economies sometimes masking the underlying pressure on supply). As a result, there has been the development of what I term 'hyper-competition', in which limits in the growth of commodity supply means that a finite supply of commodities generates a zero sum game (for those new to the blog, read a more comprehensive explanation here).

Alongside the problem outlined above, there was a flood of money entering into western markets from the petro-states, from the emerging economies, and from Japan (partly as a result of their policy of printing money). This is the root of the financial crisis. Whilst money flooded into the banking system, the opportunities to invest in new productive capacity was limited. The smart money for such investment was going to the emerging economies. With limited capacity to invest the money in productive investments, the money was instead moved into consumer lending, presenting the consumer credit markets with a flood of money. The result was the housing boom and bust, and consumers gorging on the credit. This consumer debt driven boom hid the underlying changes in the world economy and the emergence of hyper-competition. Even as the emerging economies were growing more wealthy, their wealth was recycled into consumer credit, and much of the Western world appeared to be in rude economic health, as the wealth of others was consumed in the Western economies. The Lehman crisis simply highlighted that much of Western growth was built upon the foundations of sand of a credit bubble (sorry to mix metaphors here).

Governments were totally oblivious to the crisis that was taking place. They mistook growth founded upon unsustainable increases in debt as underlying economic growth. A raft of economists gave explanations for this fantasy of economic growth and provided comfort; the West would do all the added value whilst the rest of the world did the messy business of making things, the service economy was the new paradigm, boom and bust had been ended, the great moderation was taking place. One of the factors that was so important was the apparent growth in GDP whilst inflation remained subdued. That this was the result of the lowing of labour and other costs in the emerging economies was ignored. Central banks, and the banking regulators were no better. They likewise considered that all was well. They devised rules and regulatory systems which were based upon fantasies that they could uniquely see risk in the future. If you do doubt this, look at the Basel banking accords. As just one example, Basel I regulated OECD sovereign debt and OECD banks as safe investments in relation to banking stability. Apparently, they knew what was safe and what was not. Their rules and regulations were fantasy.

The Lehman crisis revealed to the world that all was not well. Much of the banking system was insolvent after recklessly lending into to the consumer boom. They had hidden the risk in a multitude of ways, creating an illusion of stability. Lehman's was not alone, but was just an exemplar of an insolvent system. The response to the banking crisis was to pour every resource possible into the banking system. Governments provided direct financial support, and central banks poured even more support into the banking system in less transparent bailouts, whilst accounting rules were relaxed to hide bank insolvency. The idea of 'too big to fail' was discussed, and used as an excuse to save insolvent banks. The result was ever more concentration of the banking system, making the potential failure of one of the major banks ever more dangerous. Supporting the massive bank bailouts was a massive allocation of resource from the government, which saw government debt increased to support the banking system. Somewhere, the politicians and economists had forgotten, or were ignoring, the function of banks.

The function of banks is to allocate resources into productive investments. They are a service provider to the economy providing support for economic growth. Instead, the rest of the economy is supporting the banking system. The bailouts represent the rest of the economy paying for the banking system's failures. Banks have ceased to be a support to economic growth, and are now a drain on economic growth. The productive parts of economies, one way or another, are paying for the support of the banking system. After all, resource must come from somewhere productive. To add insult to injury, the salvation of the insolvent banks has seen the banks return to 'profit', and the re-emergence of the big bonus culture. Whilst the rest of the economy is still paying for the failures of the banks, those running the banks have emerged from the crisis as wealthy as ever, and as powerful as before (if not more so).

Has anything changed with the banking system? The answer is yes and no. In Europe, the European Central Bank (ECB) is busy in the task of bailing out the European banking system. They are flooding the banks with easy money, with one wag (I forget who) suggesting that the ECB will take a bus ticket as collateral for loans. When the federal reserve supplies liquidity into Europe, the federal reserve is concerned about US bank exposure to Europe's banks. The EU crisis is not only about sovereign insolvency, but about the potential damage to the banks exposed to sovereign default. And this is one of the changes. The banking system is not only exposed to bad consumer credit, but also to bad sovereign credit. Again, their recklessness is backstopped. The banking system remains outsized in relation to the rest of the economy, and the risk taking continues unabated, with the too big to fail banks larger than before. Yes, there have been regulatory tweaks, but the problems remain. The major banks have simply learned that whatever happens, they will be rescued. Heads they win, and tails they win. Someone is paying for their bets, and that can only mean the productive parts of economies.

It is argued by many economists that the bailouts were regrettable, but they saved the Western world from depression. In doing so, they assume that the West has been saved from depression, and that conclusion is premature. The response to the economic crisis in most countries was for government to replace the consumers as the engine of credit driven economics. Many governments have gone on a debt fuelled spending spree. As growth in consumer credit driven consumption abated, governments stepped into the breach, and grew the rate of their own debt accumulation. Some countries are now starting to address the problems of the growth in government debt, but much of it is too little, too late and too timid.

There was always a fundamental problem, and one that is not recognised by most economists. The structure of economies that enjoyed the consumer credit boom were adapted to service the consumer credit. As a basic illustration, when a person used their housing equity to buy the BMW car that they always dreamed of, this put money in the hands of the BMW dealer, and orders into the BMW factory. This in turn put money in the hands of those businesses, and the workers working in those businesses, and this money then flowed into support other sectors of the economy. This shaped the structure of the debt consumption economies. We can see in Greece what happens when debt derived consumption takes place, by seeing the reversal of debt driven consumption. The real shape of the economy emerges when the credit flow stops, and it is not a pretty sight.

When governments replaced the consumer as the borrower and consumer, they were seeking to support an economic structure built upon endless growth in the accumulation of debt. It was never going to work, as there must come a point in time where the growing mountain of debt can no longer be supported. Whilst the growth in debt provides an illusion of stability, in the end it must stop, and economies must then (like Greece) face the reality of the underlying size of their economies without debt growth. This brings me to the myth of expansionary fiscal austerity. The myth is that, if governments reduce their borrowing (note, not stop), economies can expand as they do so. However, if a government stops borrowing and consuming, parts of the economic structure supported by that borrowing and consuming must contract. Whilst reducing borrowing is absolutely essential, the pretence that this can be achieved without economic contraction is pure fantasy. Again, Greece is an exemplar, but we might also add the examples of the other economies that are seeking to reduce their rate of borrowing.

There are those who argue against reducing the rate of debt growth by governments. They argue that it is 'self-defeating'. In a recent post, I hope I (and some of the commentators on the post) punctured the logic of the self-defeating argument. In short, the logic is one in which debt based consumption creates an illusion of an ability for governments to pay for its existing debt, whilst allowing more debt to be accumulated, which requires more debt to be accumulated to continue to pay for existing and rapidly accumulating new debt. It is not easy to explain in brief, so you may wish to read the post, and some of the further explanation from the commentators here.

And so we come to the situation of the major economies. Let's start with the US, which has again been discussed as being on the road to recovery. However, it is necessary to remember that the US is currently accumulating massive government debts. It would be easy to provide a more detailed account of the current US situation (which I will do another time), but this is sufficient to tell us that the US is in no way close to recovery. The US can only be said to be in a position of recovery when the rate of debt accumulation goes into reverse, and if the economy were to continue to grow. The same applies to the UK, where the word austerity is thrown about, even whilst the levels of government borrowing are at record levels. The situation in Europe is one of ongoing crisis, pretense that the crisis is resolved, before crisis reappears. Expansionary fiscal austerity is being tried and is, of course, failing. The future of the Euro looks ever more questionable, and the fallout of a major sovereign default such as Spain does not bear thinking about. Whilst each rescue plan produces a respite, the crisis continues to pop back into life. I see nothing except some kind of fiscal union that might stem the tide and the idea of a fiscal union is highly improbable.

In the case of Japan, it is also facing problems. They are unusual in that their government debt is funded by Japanese savers, but demographics are working against the government. Those savers are starting to draw down on their savings, and that will start to finally strain the debt mountain accumulated by the Japanese government. Furthermore, as an exporter, Japan is exposed to the travails of the Western world. A similar picture emerges for China with regards to exports. However, in the case of China, there is a different problem. The statist economics that served China well in the early stages of economic development are now showing their limits. In fact, it seems that China has learned some bad lessons from the West in economic management. They have created their very own real estate bubble.

China's statist approach is also seeing broad based malinvestment, and they are now seeing the fruits of this in their banking system. When they first commenced their opening of the economy, it was difficult for investment to be anything but productive as the economy was so backwards. As the economy has grown, the easy opportunities for investment have diminished, and the result is poor state led investment. The cozy relationship between the state banks and local government, alongside corruption that accompanies such a relationship, has seen curiosities such as building cities in which nobody lives, but this is likely just the tip of a very large iceberg. It is quite possible that the combination of this poor state led economics, in conjunction with the problems in Japan and the West, may see the Chinese miracle come to an end. At the very least, it seems probable that growth in the Chinese economy will slow markedly. This may be a problem for stability in China. Again, at the very least, China is unlikely to be the engine of world economic growth that many assumed it would be. This is a change in the world situation. China has emerged from this crisis as a major economic power, but the contradictions/problems of their state led system are starting to show.


In the end, the real point of this rambling review is to suggest that whilst the situation has changed, it has not changed in some fundamental respects. In particular, the economic theory that saw economists blinded to the reality of the change in the world still holds sway. Behind the policy responses to the economic crisis, the same (or similar) cast of characters are still acting in devising policy based upon economic theory that does not work. Or rather devising economic policy that hides economic reality for a little longer, whilst all the time building ever greater future problems. If you were unwell and visited a doctor, and the doctor told you all was well, you might believe the diagnosis. However, if you later found that you had been suffering from advanced cancer at the time of the visit, you might consider that there was a problem with the doctor. In the case of economics, we are still using the same economists and same economic theory that failed to diagnose the disease. And their prescription for the economy is based upon the same economic theory that failed to diagnose the disease until the results were so apparent that they could not be missed. Continuing the analogy, the economists can see that there is an illness, but their theory is unable to diagnose the disease. As such, they are prescribing economic medicine on a poor diagnosis, and with a poor theory of how the economy works.

The disease in this case is debt driven consumption. Debt is not, of itself, a bad thing. Debt is the foundation of investment. It can produce new products, innovations, new systems of production, new factories, new service industries, and so forth. In moderation, it can help individuals. For example, a mortgage allows a person to eventually own their own home. The problem with debt arises when debt becomes a means to fund consumption now, at the cost of less consumption in the future. When so-called growth is built upon nothing more than ongoing growth in debt levels to fund consumption, unless real productivity growth exceeds the rate of debt growth, there must be a future contraction. The longer the period of debt consumption continues, the greater the eventual contraction; the longer the period, the more the economy is structured to service debt based consumption.

If you doubt that economic theory is fundamentally wrong, think of the widespread use of GDP as a measure of the 'health' of an economy. If country A borrows $1 billion from country B, country A will see growth in GDP as a result. The borrowed money will be used and will create economic activity in the economy. This consumption of the resource of another country will see GDP growth in the borrowing country. Or even more absurd. Hurricane Katrina was a good thing. All the activity needed for rebuilding would result in an increase in economic activity, and therefore a growth in GDP. Nevertheless, just about every economist, all governments, and all policy makers use this measure. It is no wonder that they all misdiagnose the disease. They have a tool for diagnosis that is no better than a doctor trying to diagnose cancer with a telescope. And this is the result; more consumption based debt growth solves the problem of consumption based debt accumulation. 

So my conclusion. The world has changed, the situation has changed. However, the policy devised to meet the crisis is founded upon the same fantasy. The change of the situation is not for the better, but for the worse. It is policy that chases a measure, and that measure is so flawed as to be dangerous. As such, nothing has really changed, as policy is stumbling blindly forwards, ignorant of the flaws in the measure upon which it is based.

Note 1: Many thanks to those who contributed to the last post with very good comments. I am always impressed with the standards of the comments on the blog, which suggests that the blog readership are an impressive group of individuals. The comments, I felt, added significantly to the value of the post. I did suggest that I might publish an explanation that explained my point better. However, in the end (and I am of course biased), I felt that they added to explanation rather than presenting a better explanation.

Note 2: I was tempted to include money printing in the content of the post, but the added complexity that this throws in to the scenario would hinder making the point I wanted to make. For those who read the last post, they might note that it is a follow on from the post, but setting some context around it.

Note3: My posting will continue to be patchy for a while, as I am extremely busy at the moment. My aim is to do a proper review of the US economy next, but that will demand a lot of time. Also, circumstances may sway me in another direction. However, I will try my best to find the time for the review.

Update 13 April, 2012: Ronanpeter (see comments below) has kindly provided a reference to some critiques of GDP by mainstream economists. As I am short of time, I browsed through the shorter narrative section, and it appears that (in places) there is some recognition of the problems that I describe (the section on country balance sheets is a move in the right direction). However, the focus of the paper does not reflect the critique given here. GDP measures are seen as inadequate, rather than being dangerous. Nevertheless, it is a positive to see that this measure is being subjected to some critical scrutiny.

Lord Sidcup has provided a link to a talk in the comments below. It is highly recommended. As per Lord Sidcup's comments, skip the first 10 minutes.

Austerity and Luxury

Things are going from bad to worse, which is no great surprise. There is currently plenty of coverage of bond yields, national debt status (government and privately originated), so I will not repeat what is covered in such depth elsewhere, and have just linked to a very useful Economist interactive chart below:

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.

And:

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 necessity

It 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.