Thursday, 26 September 2013

Austerity may be wunderbar

Five years on from the tsunami of the Lehman’s default and subsequent recession it’s probably a good moment to assess the relative merits of the monetary and fiscal strategies that developed countries have deployed to reboot their economies.  There have been a range of initiatives that have been tried but the “standout” response has been austerity, which can also be derived as a noun – austerian and there is even an antonym – Krugman!
To understand the impact of austerity it’s necessary to look at how this much used and abused word has actually been implemented in different economies.  In the UK George Osborne used the cover of austerity to keep borrowing more and more money.  He talked of austerity while practicing traditional Keynesian economics.   This austerity mood music hoodwinked the markets for a while into thinking we were attending to our debts when in fact we were still bingeing away.  Finally, the ratings agencies caught up with us but not before they had down-graded everyone else, allowing us to continue borrowing at very low rates in the money markets.  As the UK was saddled with one of the highest levels of private debt (over 140% of GDP) we have gone through a sharp deleverage and if this drop in demand had been augmented by real austerity we may have had a much worse outcome and we are now enjoying.
Through luck more than judgement Osborne’s real cut backs are only coming through now, when the recovering economy can deal with the squeeze.  The result of this happenstance is that employment rates have been protected despite some shrinkage in the public sector.  For those in work living standards have dropped significantly as employers have cut back on hours and bonuses, but as disposable income is marginal we can expect a quick recovery now we are growing again.  One might also say that the UK has done well from other people’s austerity.  Recessions and near bankruptcy in the Eurozone has allowed us to enjoy low interest rates and massive capital in-flows that have now kick-started our economy.

In Greece, Spain and Portugal austerity has been real and heart rending, putting millions out of work and turning the clock back on years of economic “growth”.  State sponsored austerity in Europe as practiced in the PIIGS economies is actually the brain child of Angela Merkel.  Frau Merkel took a very dim view of government indebtedness in stark contrast to her predecessors who, in the early years of the Euro (1999-2003) ran large deficits to help fund re-unification costs and to kick start Germany’s dawdling economy.   Merkel has been steadfast in her belief that economic recovery is dependent of manageable levels of debt.  This has been a relatively easy conclusion to come to as Germany has been able to combine debt reduction with an export boom and very low interest rates, whereas the PIIGS had to deal with austerity, poor productivity and high interest rates – enforced on them as a risk premium by the banks.

German Austerity 
Do these two different tales of austerity inform us as to whether continued or even accelerated public spending would have dealt with the recession and indebtedness more effectively than austerity.  Paul Krugman, in his assessment (brilliantly done) of the search for growth after the credit crunch and the role of austerity, opines that without fiscal stimulus monetary policy alone has struggled in stabilizing shrinking economies.  He believes passionately that interest rates alone were never going to provide sufficient stimulus to spring us from the demand slump that followed the crash. He us “ ..but fiscal discourse went completely off the rails, and overall we had unprecedented austerity when we should have had stimulus.  So we’ve had an economic disaster”.  

The equation is therefore quite simple.  Do the disadvantages: shrinking demand, rising unemployment and wasted capital, out-weigh the advantage of low interest rates, secured on that back of this prudence, or not?  Clearly low interest rates have worked in Germany were they have enjoyed a quick rebound.  In the PIIGS economies, whilst they have the same base rate as Germany rates have been much higher and this is what has given austerity a bad name.  Austerity with high interest rates has become a zero sum game for the un-productive highly indebted economies, whereas it’s been a success in Germany.

Productivity has also been a vital variable in how austerity might play out.  In high productive economies employers want to maintain their skilled and valuable workforce and will withstand lower profits to do so.  Also productive economies tend to have more flexible employment cost structures with more variable pay, this allows employers to reduce costs but retain staff when demand dips.  In less productive economies employers will automatically shed staff in the short term knowing that they can rehire easily when things pick up.  Another benefit of the productive economy is that you can expect inward investment.  Economies like the UK that have been able to attract foreign capital flows an alternative counterbalance to austerity and a means to spring the liquidity trap; but the less productive southern states in the Eurozone have not been so lucky.

We can probably learn a few of things from all this:
  1.  If you don’t control your interest rate or currency (Eurozone economies) austerity may be a bad thing
  2. If you have an unproductive economy with little spare capacity austerity will be a bad thing
  3. If you have no track record of attracting inward investment austerity will be a bad thing
  4. But if your Germany austerity may be wunderbar

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