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. 

Anti-Austerity in Europe

I watched the outcome of the French election with considerable interest. It seems that anti-austerity is becoming a major force in Europe. Even more interesting is the collapse of the will for austerity in Greece.

It is a quite fascinating situation, which is also quite alarming. It is fascinating as the 'Krugmanesque' vision of economics may finally be put to the test. That is, it seems that it may now be the case that the borrow and spend spigots will open for already 'in trouble' economies. As regular readers will know, I do not deny that borrow and spend will indeed create employment. After all, it is not difficult to spend somebody else's wealth on make-work activity or paying for activities that would otherwise not be affordable. I do not deny that this will create more tax revenue. If more people are working, and more are spending, then indeed this will indeed create the activity in the economy that will garner greater tax revenue. Likewise, this increased activity will appear to either slow economic shrinkage, stabilise, or even grow an economy.

The problem is that it is very, very easy to spend the wealth of others in generating activity. The problem is that this borrowed wealth will eventually need to be returned to the lender. This in turn generates the problem that, if people doubt the borrower's ability to repay, then they will not lend. The question then arises as to whom, exactly, these want to be borrowers might actually borrow from. It is all very well for people to march on the streets and demand an end to austerity, but they are demanding that governments spend money that they do not have. However much these marching/protesting individuals and their political leaders demand borrow and spend, they have a problem. The problem is simple. They simply do not, within their own country, create the wealth that they desire. That is why they must borrow.

The wealth that is desired by the protesters and their political leaders only exists external to their own economy. It is not theirs, and short of going to war, they can only access this pool of wealth if the holders of the wealth choose to allow access to it. No amount of protest, political rhetoric, demands, tantrums and so forth, will change this.

Of course, there is always the possibility of raising taxation in a country to pay for all of the government spending. It is always possible to squeeze the pips out of the wealthy. Or at least, as long as the wealthy hang around to be squeezed. However, the term capital flight is not abstract; there comes a point at which people feel that the redistribution of their wealth to others is unacceptable, and they will choose to remove their wealth to a place where such a redistribution will not take place.

Even if accepting that the wealthy can be squeezed, the 'in trouble' economies will have to squeeze very hard  to make up for the loss of borrowed wealth from external sources. And that is the problem; even if increasing taxation for the wealthy, will governments be able to manage without the borrowing of external wealth to pay for all of their reinstated/increased spending programmes? I mean really; can this do the trick? I very much doubt it. 

The plans of the anti-austerity movement are quite remarkable. They are remarkable in that they assume that there is some hidden source of wealth that is the right of their country. They do not have, or produce, this wealth themselves, but are apparently entitled to it. If the anti-austerity movement wins out, we will be able to see whether the Krugman approach actually really works in practice. I read recently that Krugman's view is influencing political leaders in Europe; that his proposed remedies are believed to be the solution.

Of course, there is nothing to say that some of the 'in-trouble' economies might not borrow a bit longer. For a while at least, the Krugman solution may appear to work, and encourage others to speak out/act against austerity.The success of anti-austerity will, if this takes place, be trumpeted as a solution - at least up to the point that the lenders of wealth lose all confidence. As an analogy, think of the Jurassic Park films; there is a sequence in which the lead character says something along the lines of; 'That's how it always starts, with the oohs and aahs, but then the biting and the eating starts'.

So, if the anti-austerity movement wins for a while, those in favour of the movement will sound out their 'oohs and aahs', but when all confidence is lost, the picture will change dramatically. It is quite possible that we are about to witness a real world economic experiment, in which the theories of individuals such as Krugman will finally be tested. They believe that wealth can simply appear by borrow and spend/tax and spend. They believe this will create a virtuous cycle that will fix economies.

I, on the other hand, believe that wealth is, in the end, created by creating a framework in which individual endeavour creates real wealth. This individual endeavour, whether from a bricklayer or a the CEO of a multinational, is the real source of wealth creation. They make products and services that people want, and can pay for the goods and services as a result of their own individual endeavours. The relative success of these individual endeavours, in aggregate, in terms of productivity, and in relation to other countries, determines the real wealth of a country. Not borrowing.

I suspect that we are about to find which vision of economics is correct. I hope I am wrong. If I am not wrong, then the outcome may be very disturbing.

The Greek Crisis

I don't know about the readers of this blog, but I am now at a stage of simply being overwhelmed by the ongoing and endless rescues of the Euro. Every day the news pours out on the latest initiative, the latest plan, the latest crisis meeting/summit, the latest bad news......In light of this, it was a pleasure to read the latest take on the story from Spiegel Online, which cuts through much of the fluff on Greece. The headline and sub-head offer a great summary:

European Politicians in Denial as Greece Unravels


Europe's politicians are losing touch with reality. Greece is broke, and yet Brussels wants to send the country billions in new loans, to which there is growing opposition within the coalition government in Berlin. Rescue efforts are hopelessly bogged down by bickering over who will ultimately step up.

This was the part that I really liked:

The Greek economy is not productive enough to generate growth. Aside from olive oil, textiles and a few chemicals, there are hardly any Greek products suitable for export. On the contrary, Greece is dependent on food imports to feed its population.

"Greece has been living beyond its means for years," an unpublished study by the German Institute for Economic Research (DIW) concludes. "The consumption of goods has exceeded economic output by far."

Especially devastating is the assessment that the DIW experts make about the condition of an industry that is generally seen as a potential engine for growth: tourism. According to the DIW study, the Greek tourism industry concentrates on the summer months, with almost nothing happening throughout the rest of the year. There is almost no tourism in the cities, which translates into low overall capacity utilization and high costs for hotel operators. By contrast, capacity utilization in the hotel sector is much more uniform in other Mediterranean countries.

I have long argued that this is one of the fundamental problems that sits beneath the economic crisis. It is the fantasy that a country can just continue to endlessly consume more than it produces. Whilst Greece may be an extreme case, it is very apparent that Greece is not alone. I am going to quote at length from the first post of this blog, which is from an essay I wrote in 2007:

I am going to start by looking at the world from the point of view of many modern economists. Whilst none of the economists would accept that what I am about to portray is their belief, when you look hard, you will find that this must be their basic belief. If not, then they have no justification for their pronouncements of success for the UK economy.

Imagine a family living in the UK, not an atypical family, not a typical family, but an ordinary middle class family. We will call them the Wilsons. The father has a job in management for a chain of retailers, and earns £30,000 per year. The mother has a good job in a local hotel where she is the marketing manager and earns £30,000 per year. They therefore have an income of £60,000 a year. They have two children at the local school.

The Wilsons have purchased a home, which cost them £300,000, which is five times their combined income, using a 95% mortgage. The house has increased in value by £30,000 a year, in each of the three years since they purchased it. They are very pleased to see their house growing in value, as it is like having another earner in the house, except this earner pays virtually no tax on the income, making it an even better earner than themselves.

The Wilsons have a relatively large mortgage, but interest rates are low. Despite this, they struggle to balance the quality of life that they enjoy against their income. As such, they make use of credit cards to occasionally purchase items. Each year, for three years, they have added £6000 to the family debts through overspending on the ‘little luxuries’ in life, such as holidays, and new goods for the house. At the end of the second year in the house, Mr. Wilson decided that he would fulfil his dream of owning a Mercedes, and re-mortgaged the house to realise £20,000 of the increase in value of this asset. He used this as the down payment on the car, and took a loan for £20,000 to pay for the remainder.

Overall, the Wilsons non-mortgage debt stands at £18,000 for the credit cards, and £15,000 remains of the loan for the car. They are starting to find the payments on these debts are stretching them, and they seem to be using the credit cards a bit more often than before.

Next door to the Wilsons live the Jones family. The Jones family know and respect their next door neighbours. They can see how successful they are. They are always doing something to the house, making improvements, and they seem to be living the good life. Only recently the Wilsons bought a new Mercedes and Mr. Jones feels a little jealous, as he would love a Mercedes too.

The Jones family, have less income than the Wilsons, but every year they save a few thousand pounds. They have no debt except for their mortgage, and only spend what they earn. They purchased their house at the same time as the Wilsons, and are steadily paying their mortgage. Their belts are tight, but they get by, and look forward to better days ahead.

Which of these two families is the more wealthy family?

The answer largely depends on whether you are an economist who has been a cheerleader for the boom of the last ten years, or whether you are a person grounded in the real world. The Wilsons have been the motor of growth in the Anglo-Saxon economies. Apparently we have gone through a period of sustained growth and, in moments of hubris (Gordon Brown in the UK being a wonderful example), we promote the ‘success’ of the Western economies to the rest of the world. The trouble arises when we ask a simple question; ‘Where is this growth?’

The Greeks are the Wilsons. Yes, they have lived a good life. But the bills have simply grown to the point where they do not have enough income to repay them. This aspect of economics has never been complicated. If you are continually borrowing to pay for consumption, you will indeed have a high standard of living - for a while. Unless your income growth is outstripping the rate of debt accumulation, it is only a question of time before the credit becomes too much to service. It is not a case of 'if', but 'when'.

It is very curious how much effort and time goes into denying this simple formulation. The answer to the problems of too much debt is apparently to just borrow more....We see it endlessly from economists, politicians and commentators. Austerity is self-defeating. The answer is to borrow more. 'Yes', when borrowing more, the economy will appear to grow. Just like the Wilsons, there will be an illusion of wealth for a little longer. However, like the Wilsons, it can not change their actual real income; it cannot change the ability to create real wealth.

The Spiegel article gets to exactly this point with Greece. Greece simply does not have the ability to continue to have the high standard of living that it has previously enjoyed. That standard of living was supported by unsustainable debt accumulation. They just do not create enough wealth to either continue to live as they have done, or pay back the debts accumulated in giving them an illusion of wealth.

I just do not understand how it is that this simple and evident reality can be ignored by so many. In the case of Greece, it is plain to see. And just as it is plain to see in the case of Greece, it is also plain to see in the cases of other economies. They may not be as dramatic as Greece, but the same principle applies.It really is very simple.

Austerity in the UK

I know I bang on about Krugman, but his pronouncements become ever more silly, and I would like to relate his latest silliness to the post above. This is his commentary on austerity in the UK:

Britain, in particular, was supposed to be a showcase for “expansionary austerity,” the notion that instead of increasing government spending to fight recessions, you should slash spending instead — and that this would lead to faster economic growth. “Those who argue that dealing with our deficit and promoting growth are somehow alternatives are wrong,” declared David Cameron, Britain’s prime minister. “You cannot put off the first in order to promote the second.”

[and later]

And we may get tipped in the wrong direction by Continental Europe, where austerity policies are having the same effect as in Britain, with many signs pointing to recession this year. 

The infuriating thing about this tragedy is that it was completely unnecessary. Half a century ago, any economist — or for that matter any undergraduate who had read Paul Samuelson’s textbook “Economics” — could have told you that austerity in the face of depression was a very bad idea. But policy makers, pundits and, I’m sorry to say, many economists decided, largely for political reasons, to forget what they used to know. And millions of workers are paying the price for their willful amnesia.

There is one very fundamental problem with his use of the exemplar of the UK for the evils of austerity; there is no 'austerity' in the UK, just talk of it. It is a point made very well in a post in the Money Illusion:

But I am seeing article after article claiming that the coming recession is due to fiscal tightening.  I was curious to see just how tight British fiscal policy actually is, so I checked the “Economic and Financial indicators” section at the back of a recent issue of The Economist. They list indicators for 44 countries, including virtually all of the important economies in the world.  Here are the three biggest budget deficits of 2011:
1.  Egypt  10% of GDP
2.  Greece:  9.5% of GDP
3.  Britain:   8.8% of GDP
Egypt was thrown into turmoil by a revolution in early 2011.  Greece is, well, we all know about Greece.  And then there’s Great Britain, third biggest deficit in the world.

There is absolutely nothing that can be described as 'austere' about the rate of borrowing in the UK. Quite the opposite - it is shockingly profligate. In reality, the UK is doing exactly what Krugman has long argued for, and has now been doing it for a long time. The UK is borrowing and spending with abandon. The really shocking thing about the UK economy is that, despite following this reckless path, it is still seeing shrinkage of the economy.

What Krugman means is that the UK government should increase the rate of debt accumulation to even higher levels. It is his solution to all ills. Just borrow more, or print more money. He cannot even see that the UK is already doing exactly what he recommends, that it has been doing so for a long time, and that it has not worked. Quite the opposite. For all the debt accumulation, the UK economy is still shrinking.

As regular readers know, I do not argue the case of expansionary austerity. I can at least agree with Krugman on this point. Real austerity will be a hard and painful path. If the UK were to balance the government budget tomorrow, the UK economy will nosedive. However, as I argue above, in the end, there is no real choice but to see the economy nosedive at some point. It is not 'if', it is 'when'. Again, as argued above, Krugman's solution will keep the illusion going for a while, assuming that bond markets play ball, but it will only prolong an illusion.

In the post above, I talked of the way that modern economists might see the two families. At the time of writing I was not familiar with Krugman. However, he is exactly the kind of economist who would propose that the Wilsons are the wealthier of the two families. He seems to really believe this......it is shocking. It is why his pronouncements are so very, very wrong.

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.