STOCK MARKET WATCH -- Monday, 9 July 2012

[Demeter]

6. Rob Parenteau: Blinded by Faith – Sinking the Eurozone

http://www.nakedcapitalism.com/2011/10/rob-parenteau-blinded-by-faith-%E2%80%93-sinking-the-eurozone.html?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+NakedCapitalism+%28naked+capitalism%29



By Rob Parenteau, CFA, sole proprietor of MacroStrategy Edge and a research associate of The Levy Economics Institute

Wolfgang Munchau has raised a very important point in his current Financial Times article, “Why Europe’s officials lose sight of the big picture.” The eurozone, Wolfgang points out, is more like a large closed economy than a collection of small open economies, and this has implications for fiscal policy outcomes, yet these implications remain largely unrecognized by policy makers within the region. Wolfgang noted:

The many failures of the eurozone’s crisis response policy have a common cause: the eurozone is a large closed economy. Each of its 17 members is small and open. The political leaders who run the eurozone have a small open economy mindset – every one of them, without exception. The economists they employ mostly use small, open economy models.

Right at the moment, the failure to adjust to the necessities of a large closed economy is the single largest force behind the crisis. Small open economy thinking has brought us uncoordinated fiscal austerity packages. Jointly, these programmes have had a profoundly negative effect on growth, one that the small open economy crowd was unable or unwilling to see. All forecasts for economic growth and budget deficits have been too optimistic because governments failed to take into account their full impact. Not only Greece and Ireland are missing their targets, but so will Spain and Italy. I expect a full-blown recession in Italy next year, and an overall increase in the deficit. So the net effect of austerity will be an increase in debt.

In one sense, Wolfgang is merely suggesting that policy makers did not take into account the spillover effects within the eurozone of each country pursuing fiscal consolidation programs at the same time. There is something of an element of the fallacy of composition at play here. If only one country pursued budget cuts and tax hikes in order to reduce its fiscal deficit, the influence on the remaining eurozone nations would be relatively minor, and the attempted cuts might be successful in reducing the fiscal deficit of the country in question. However, if the majority of nations in the eurozone pursue fiscal consolidation programs – programs that are not only ambitious in size and scheduled to be pursued over several years in a row – then the spillover effects should not be ignored. However, while this pursuit of simultaneous, multi-year fiscal consolidation can only thwart itself by dragging down growth and dampening tax revenues, thereby leading perversely to still higher public debt outstanding, the problem does not lie so much in failure of policy makers to recognize and take into account the interactive effects of fiscal consolidation across countries. Rather, the truth of the matter is that most of the eurozone policy makers and their erstwhile economic advisors are practicing a faith based economics. They believe in the moral purity of balanced fiscal budgets. They also believe private sector activity will pick up to more than compensate for public sector cutbacks. That is the essence of the Ricardian Equivalence Theory, which is a central theoretical proposition that mainstream economists believe in and teach every graduate student to parrot.

Simply put, under Ricardian Equivalence, fiscal deficits are supposedly neutralized by the attempts of the private sector to save more money out of income flows in order to service future tax burdens they anticipate will be required to service the higher public debt implied by the fiscal deficit. To be symmetrical, Ricardian Equivalence must also hold that fiscal surpluses are likely to be neutralized by the private sector deficit spending (that is, spending more money on produced goods and services than it earns from current production). We are left, in other words, with the defeatist conclusion that fiscal policy is fairly impotent with respect to influencing economic growth. It is back to changes in the outstanding stocks of productive capital, available labor and materials and other supply side determinants of growth, with Say’s Law tacked on top of that to insure that miraculously, supply creates its own demand. However, this symmetry was either broken or ignored by eurozone policy makers who took up the call for what they termed “expansionary fiscal consolidations”, like we saw in Sweden in the early ‘90s and Canada I the mid ‘90s. It is indeed possible to find expansionary fiscal consolidations in history, but the fact of the matter is that they appear to be possible only under very special conditions. They turn up most frequently in small open economies that have undergone a large currency depreciation while their trading partners are experiencing robust foreign growth. They also turn up when sufficient interest rate relief accompanies fiscal consolidation (either due to central bank easing, or bond investors improved outlook and confidence with the commitment to fiscal discipline, or both) and private domestic demand is highly sensitive to changes in interest rates.

Unfortunately, these conditions do not obtain in the eurozone at this time (nor are they apparent in the UK or the US), and policy makers still refuse to acknowledge that an expansionary fiscal consolidation requires special conditions. Many of us pointed this problem out in various forums over the past two years when politicians were pushing the expansionary fiscal consolidation line. (For example, please see my prior posts on Naked Capitalism and elsewhere, especially the “Leading the PIIGS to Slaughter” pieces, as well as my presentations at the Levy Economics Institute annual Minsky conferences in 2010 and 2011, particularly the audio and PowerPoint files from session 4 on Thursday during the 2010 conference, which can be found here). Apparently, they were just deaf to it all. In addition, the policy makers in the core believe in the sustainability of export led growth strategies. Keynes warned about this in the last piece he published before his death. If the reserves earned by current account surplus nations like Germany, Austria, etc. are not reinvested in productive capital equipment and structures in the current account deficit nations, then the deficit nations will not be able to earn the income required to service their external debt in the future. They will default. Or, as economist Jan Kregel put it in very clear terms, if Germany wishes to sell exports to the periphery year after year, Germany can chose to accept either liabilities issued by the periphery, or tradable goods provided by the periphery, but they do not have the option of choosing neither.

It is not in the best interest of the creditor/current account surplus nations to continually accumulate liabilities issued by debtor/current account deficit nations if this simply leads to eventual default on those obligations, but the economists and policy makers in the eurozone are too myopic and too blinded by faith to see this. The European Investment Bank could be used to recycle current account surpluses into productive capital investment in the periphery in a sustainable fashion, but instead, policy makers remain wedded to the faith based economic belief that export led growth strategies are both sustainable and optimal. This neo-mercantilist faith would, by extension, have every nation in the world running a perpetual current account surplus, which is clearly a mathematical impossibility – at least until we find life on Mars that is prepared to barter and truck with us.

Wolfgang cuts far too much slack for eurozone policy makers and economists by arguing their main problem is that they do not realize they are dealing with a large closed economy, and so they are ignoring the spillover effects of the mutual pursuit of fiscal consolidation. But let’s take Wolfgang’s logic on its own. If piece-wise austerity cannot work for everyone because of the fallacy of composition, and hence it will only lead to a failure to meet fiscal targets and higher public debt (as we are witnessing in Greece, Ireland, Spain, and elsewhere), then perhaps it is time to recognize that coordinated fiscal stimulus could work for everyone, possibly even without increasing anyone’s public debt or fiscal deficit!.....It is not just that they ignore the fallacy of composition, Wolfgang. They believe in outright lies (and do ask yourself, which interests are served by those lies). They belong to the cult of neoliberalism, and it is killing the rest of us. To their three decade old claim of TINA (there is no alternative to the neoliberal agenda) it is time to see them, and raise them one with the cries in the streets of AWIP (another world is possible). It is high time to toss aside the faith based economics of the neoliberal era and build a world worth living in.