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Thoughts from the Frontline

Austerity Is a Consequence, Not a Punishment

April 20, 2013

Two seemingly different questions and comments from readers and friends crossed my path the last few days, but I saw a definite connection between them. The first question was, Why do we pursue austerity when it seems not to work? And then many readers wrote to ask this week, What do I think about the real problems that are surfacing in the Rogoff and Reinhart assertion that debt above a ratio of 90% debt to GDP seems to slow economic growth by 1% (especially since I have quoted that data more than a few times)? We’ll deal with each question separately and then see if we can connect the dots.

The first question comes from correspondence I have had with Ms. Aga Barberini, who works in the investment world in Milan, Italy. She came there from Poland some 20 years ago. The first part of her note contains the question on austerity, but I’ll pass along more of her letter, as I think it will give us all some insight into the seeming chaos that voters are facing in choosing a path for Italy. (And I hope my editors leave some of the charming grammar in her letter. You can almost hear the musical tones of her Italian English.)

I am worried for Italy, too. When I came here 20 years ago Italy was beautiful and rich; it was very good for a girl from Eastern Europe. Nowadays a lot of Italians go to Poland and settle down.

I guess it’s going to get worse, the austerity will be tighter. Please tell me why should we go ahead with austerity when IMF last month came out  saying that for every point of tax lifting in Italy we lose 2.5 points of GDP? First they said that the tax lifting would produce only 0.5 points of GDP slip, now they say they were wrong.

The political chaos is lasting. My husband says, why don't we vote for the comedian in June (as it is almost sure we are going to vote again soon)? Sure, Grillo is right in a lot of things and would clean the politics a lot. (By the way, did you know that the oldest bank in the world, Monte dei Paschi di Siena’s mess is reaching 20 billion euros? They took away the money doing ... the bank transfers ;-) The Banka d'Italia didn't see; CONSOB, the Italian SEC, didn't see...). But how can a serious person vote for the comedian?

But I say sometimes the one who is good for the revolution isn't necessarily good to rule the country.  Do you remember the guy called Lech Walesa? Thanks to him the communism [in Poland] was fallen – we all agree. Polish people were so thankful to him that we appointed him for the first democratic president. Than we found that he didn't have enough background to rule the country and enough culture to represent us on the international stage.

I will vote Berlusconi again. I can't stand communists even if they call themselves “the left.”

(Sidebar:  I was in Siena last summer and visited the ancestral home of the bank mentioned above, the world’s oldest, founded in 1472. I marveled that any bank could last so long. At the Palio last summer we met one of the senior managers of the bank. It turns out that it was local politicians who ran the board of the bank, and now the authorities are saying management hid the problems from them.)

So let me try to answer you, Aga.

Austerity has come to have a rather bad name of late. The complaint is that it just doesn’t work. Which is somewhat like complaining that the roof is leaking because someone else hassn’t fixed it. If by “working” we mean that austerity is supposed to produce growth, then of course it doesn’t work. By definition, austerity means you are reducing a fiscal deficit, and doing so will reduce growth in the short term. That begs the question, why would you want to do that? Don’t we want growth? Let’s look at why a country might need to endure austerity.

“Austerity” is now the name we give to the situation where a government has to limit its spending during an economic downturn or recession. The governments of the developed world amassed huge sovereign debts in the course of what is known as the Debt Supercycle. As interest rates fell, borrowing to finance consumption and spending became easy. But now that decades-long supercycle has ended.

One way of looking at the problem of swollen sovereign debt is to say that it goes back to Keynes (although one cannot actually blame the current problems on his economic theory). Keynes argued (roughly) that when there is a normal business-cycle recession a government should spend money to counterbalance the private-economy slowdown. That means that the government should borrow money and run fiscal deficits to help boost spending and the economy. According to his theory, this would make the recession not as deep and help bring the economy back to recovery sooner.

This was tried after World War II in numerous countries in the developed world, and it seemed to work. "We are all Keynesians now" is a famous phrase uttered by Milton Friedman and attributed to US President Richard Nixon. It is popularly associated with the reluctant embrace of Keynesian economics in a time of financial crisis, by individuals such as Nixon, who had formerly favored less interventionist policies. (The phrase was first attributed to Milton Friedman in the December 31, 1965, edition of Time magazine. In the February 4, 1966, edition, Friedman wrote a letter clarifying that his original statement was, "In one sense, we are all Keynesians now; in another, nobody is any longer a Keynesian.") (Wikipedia)

The problem that arose was that most countries rarely followed through on the second part of Keynes’s prescription, which was to pay back the debt when times were good. Rather, the debt just continued to accumulate. But, because interest rates were dropping, the size and cost of the debt became less of an issue.

The Bang! Moment

And, as Rogoff and Reinhart showed through their massive data collection and work on sovereign debt crises, published in This Time Is Different and elsewhere, debt is not a problem until it becomes one. And then it reaches a critical mass and you have what they called the Bang! moment.

I want to review some of their work, which will help us understand the reasons for austerity,…

Discuss This


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Warren Stephens

Aug. 22, 12:48 p.m.

Now comes this quarter’s “Foreign Affairs” with an article titled:

“Print Less but Transfer More—Why Central Banks Should Give Money Directly to the People” by Mark Blyth and Eric Lonergan

I have yet to read it… I wonder if it states anyone of my points written below?

Warren Stephens

April 30, 2013, 4:30 a.m.

What would printing money and sending it directly to households do?
* would stimulate the economy (pro-Keynesian)
* would not increase government debt (pro-Austerity)
* would not increase private debt (pro-Austerity)
* would not increase the size of government (pro-Rightwing)
* would help disadvantaged households (pro-Leftwing)
* would not directly manipulate interest rates (pro-Freemarket)

I’d say about $100 per person per month would do it (so that’s 313 million people * $100 = $31 billion per month—which is LESS than what the Fed is currently doing at $85 billion per month).

Joe Six-Pack’s family of 4 would get $400 per month, and Warren Buffett would get $100 per month.

So who is probably against such an idea?  Economists.

Warren Stephens

April 28, 2013, 5:11 a.m.

Austerity won’t work.  Stimulus won’t work.  What we have here is a failure to recognize failure. 

The solution is probably to print money (with prudence) and send it directly to households—not to the government, or banks, or the MBS market—until things improve.  Note that this is single-entry bookkeeping, there is no debt on the other side of the accounting.

The problem is that this notion does not have a pipe-smoking egghead economist (dead or alive) to endorse the idea.  But it would probably work, as the other ideas have failed.

Carl Bechgaard

April 23, 2013, 7:01 a.m.

Here is another good analysis of why Rogoff Reinhardt were not wrong:

Dallas Kennedy

April 21, 2013, 5:21 p.m.

The problem with austerity is that it’s supposed to be a transition to better growth effected by other reforms, in particular currency devaluation and systemic changes to the economy and polity. If the latter don’t happen, austerity becomes a dead end. That’s what’s happening in Europe.

The right policies start with austerity to live within your means for now, while increasing your means in the long run. For Europe, it means that (a) the euro as it’s currently set up must be dismantled or allowed to disintegrate, and (b) democratic sovereignty must be returned to the respective European countries from whom it was taken away by the Troika. Only the latter can support systemic reforms that can stick. I don’t know about the latter; but the former (the end of the euro) is a certainty.

All this propaganda about “new deals” and so on is just people peddling more stale, discredited neo-Keynesianism: it’s just inflationism. With the way QE is now working, it’s a variation on permanent financial inflation in perpetual search of a new asset bubble to blow (rather than 1970s-style inflation). All it does is to make bankers and other financial types wealthier—until the music stops (as in 2008) and those same cronies look to the central banks and taxpayers to be bailed out. It’s amazing that so-called “progressives” seriously shill for such claptrap.

(BTW, the critique of Reinhardt and Rogoff is grossly overblown. There’s not much in their results that you can’t see just qualitatively from looking their tables and graphs by eyeball. The essential conclusion doesn’t change.)

April 21, 2013, 4:03 a.m.

John seems to have ignored the effect of the 2001 and 2003 tax cuts (aka Bush Tax Cuts) in the paragraph discussing how US went from budget surpluses leading to a “US investment market with no government debt” to a place of “uncomfortable debt”.  I do agree that our debt should be financing “infrastructure” (there are still sidewalks in my neighborhood built in the late 1930s) but I see no argument for austerity imposed on the masses as a solution to that problem.

Charles Breese

April 20, 2013, 9:16 p.m.

In the UK government borrowing has allowed government to become too big. How do we know this? There is a hairdresser I know of who itemises the bill into a) money which stays within the business and the hands of its employees and b) money which goes to the public sector - item b) represents 60% of the total bill. In other words, the basic costs of cutting a person’s hair are inflated by 150% in order to contribute to the costs of the public sector. This ratio stifles economic activity. The reason I approve of austerity is because in the UK the public sector must be shrunk (because there are so many areas where it is providing poor value) and austerity is the discipline which forces the hard decisions as to where the cuts must be made - an essential step to recovery is the transfer of people from being remunerated by the public sector to being employed by the private sector.

April 20, 2013, 11:32 a.m.

There is another definition of austerity that dates back to Biblical times. It is from Genesis 41 - the story of David, Pharaoh, seven years of plenty, seven years of famine.

David told Pharaoh that during the times of plenty they should practice AUSTERITY so they would be able to survive the times of famine.

Austerity can be practiced in good times. Reality is practiced in bad times.

Bruce Rae

April 20, 2013, 10:52 a.m.

As some commentators have noted: shoddy statistics don’t give us lay people much confidence in experts conclusions about financial realities.
However, we all know that in our private lives we have to be able to finance our debt and have some plan for paying it off in the future, even if the plan involves selling an asset and making no profit or taking a loss. Our only way forward is to read a market accurately and invest in the future in an affordable way.

Therefore, I don’t see that specific levels of government debt as a ratio of GDP have any particular significance, apart from the fact that obviously the more debt you have the better your investments have to be in realising your financial vision of the future. Of course, you also have to be successful at selling your vision and track record to your financiers, which are mostly banks.

This, I think, is where one of the main problems lie. Banks are conservative and it seems that governments don’t have many credible plans for the future. Of course, many western governments don’t want to get involved in capital projects other than the construction of basic utilities and leave other development projects up to private individuals and corporations. In this regard, if America’s and Australia’s projected energy booms pay off in the next 10 years, then both of those countries will pay down a lot of existing debt because of the returns gained through the private sector. But at the moment, the US Fed and other central banks are just lending more money to the banks and in my view banks are mostly incapable at reading markets and will usually just follow governments. So, that means we are in a non-productive monetary cycle.

Yes, I’m also impressed with Singapore, which in outdated terminology would be called a socialist country. One thing that impresses me most is that apparently the government provides about 70% of the housing market with different price levels for citizens with different levels of wealth. I believe that you can buy a small apartment for S$70K and work up to a level of an apartment at about $300K (Note: the figures are only indicative). I wonder therefore, what other investments this leaves for banks to finance.

Finally, I’d like to know what happened to gold in the last week. I find it hard to believe that thousands or tens of thousands of small gold investors suddenly sold off on the same two days and took a combined hit of over US$2bn, which is a figure I read somewhere. It could only happen as a result of large holders of gold suddenly moving out of the market and being able to afford some of the loss. So, who were those gold investors? 

Art Hicks

April 20, 2013, 9:17 a.m.

Bang!  Bang is the consequences of ignoring reality. What is reality ?  Reality is BANG and Bang is the objective, it is shock and horror. What they can’t deal with is reality.
“Bang” is the frame work for a global currency by a global leader for a New World Order. It will introduce the issuance of an individual “code number” before ANY transaction can take place.
Most people prefer to believe their leaders are just and fair even in the face of evidence to the contrary, because most people don’t want to admit they don’t have the courage to do anything about it. Such as the Noahide Laws. Bill #1274 of the Georgia House of Representatives - 1995/1996 Sessions HB 1274 - Death penalty; guillotine provisions Code Sections - 17-10-38/ 17-10-44.
It’s really Not doom and gloom, just reality. ( Sorry )

=== “The individual is handicapped by coming face-to-face with a conspiracy so monstrous he cannot believe it exists.”  J. Edgar Hoover

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