Friday, April 29, 2011

There Will Be Austerity

. Friday, April 29, 2011

The inestimable Steve Waldman tries to butter me up ("excellent") before smacking down my first post on EU "Hard Keynesian" political economy:

Winecoff makes an important point, but I think he needs to cut his analysis a bit more finely. Economies run two very different kinds of deficits, a government fiscal deficit and an international current account deficit. Although the two deficits are related, there is no mechanical connection between the two. They do not reliably move together. ...

As long as the country, post-default, issues its own currency, and as long as the country’s citizenry is interested in accumulating domestic currency and debt, the government can run a budget deficit after the restructuring. The capacity of a country to run budget deficits post-crisis will depend largely on the citizenry’s confidence in domestic institutions after the fall.

This is all true, as far as it goes, and my example of Iceland as a potential comparable to Greece and Ireland (really Ireland), bears that out, as I noted in a prior post. Iceland's sovereign debt has trebled since the crisis, and presumably most of that hasn't come from foreign finance (excepting the IMF). Iceland's standards of living, from increased import costs since the devaluation, have gone down but they've still been able to borrow. In fact, as Waldman notes, a devaluation can actually increase the amount of domestic savings available for a sovereign to borrow by making consumption relatively more expensive. And a sovereign in need of funds can always make an offer too good for those with savings to refuse: either you loan us the money now and we pay you back with interest in a few years, or we tax the bejeezus out of you. Either way, we're getting the money we need.

But there's a big "as long as" assumption in there. In my original post I said that in the case of default and euro-exits, "[t]he government budget will have to be balanced almost immediately, and unless there’s a full default will likely need to run a primary surplus for many years”. Combined with my sloppy language ("almost immediately" can mean any number of things), Waldman's "as long as" can obfuscate an important point. Iceland's debt-to-GDP is now 115% at least. Ireland's debt is listed at about 100% of GDP, but of course that's a made-up number since they don't know exactly what the banks will cost them. Anyway, there comes a point when the credibility of domestic institutions gets called into question, when that "as long as" doesn't hold any longer. I think that the point of default would be as near to that point as a state can get. Governments will have a difficult time running deficits of 3% of GDP, much less 10% of GDP.

My "almost immediately" might not be instantaneous -- large shifts in government budgets generally aren't, and I shouldn't've implied that they were -- but we're dealing in the short term, not the long term. "Almost immediately" can mean austerity plans are enacted quickly and implemented over a number of years. The exact duration depends on the levels of domestic savings, and whether governments can get funding from the IMF or EFSF. But the shift from fiscal deficit to balance has to happen, and there has to be a credible plan in place in the short run, or that "as long as" won't hold very long. Indeed, in May 2009, "almost immediately" after the crisis, Iceland committed to a balanced budget by 2013, which they are on track to meet and exceed, running a primary surplus this year (pdf). That's just two years after the default. They also plan to run an overall surplus (net of interest) of at least 2.5% of GDP for at least 5 years, beginning in 2013.

All in all, I think the Iceland experience matches pretty well with my description of things. Maybe Iceland's move to fiscal balance wasn't quite as sharp as Argentina2002 or Russia1998, as Waldman points out, but it's still fairly sharp.

(An aside: Waldman claims that the EU crisis has been slow-moving enough for Irish savers to move their savings out of the country if they wish. But a huge proportion of Irish GDP, and thus tax revenue, comes from foreign banks using Ireland as a tax haven. If all those firms left, it would blow an even bigger hole in the budget. Ireland doesn't want that to happen.)

SRW's point about the difference between fiscal deficits and current account deficits is important, but let's not make too much of it. If we think of a country as a large household, then the fiscal account becomes a feeder into the national accounts. The current account reflects the difference between savings and investment, and the fiscal balance is part of that. Both public and private saving will have to go up, and/or investment will have to go down (perhaps via capital flight, but that's perhaps the worst outcome). I know what SRW is going to say: don't confuse an accounting identity for a behavioral relationship. Fine, but the fact remains: in order to balance the current account, consumption has to fall and savings has to rise. This is austerity, no matter how it's distributed. When SRW says "Shifting international accounts from deficit to balance harms citizens in their role of consumers, but serves them in their roles as workers and savers", what he's really saying is "people have to live more poorly than they did before".

Now as SRW notes, there are a number of different mechanisms for achieving this, and not all austerities are equal. I didn't say they were, but maybe I wasn't clear enough. So far, international institutions have stepped up to smooth the landing. Iceland's current account deficit has funded by the IMF, as they work to build up public surpluses. For Ireland and Greece, it's been the EFSF/IMF, as they enact their own austerity plans. Ireland's CA deficit has narrowed back to pre-crises levels, but only because of austerity, and it hasn't paid back any of the debt principal yet. Greece hasn't even gotten to that point yet. But that only smooths out the process; it doesn't revoke it.

So I don't quite buy this:

Undoubtedly, ending an era of persistent current account deficits will prove painful to consumers accustomed to cheap imports. However, that is not ultimately an incremental cost of leaving the Euro. After all, the purpose of staying and suffering austerity would be to pay down indebtedness, which is more costly than a shift to balance. Contrite borrowers have to pay interest on past debt and run (primary) surpluses. Deadbeats just need to pay for what they buy now. Quantities matter. Staying within the Eurozone offers the palliative of stretching the pain out over time, but increases the ultimate burden of the adjustment. Exiting front-loads costs, but reduces their size, as much of the work is done by the act of default. Undoubtedly, jilted creditors would punish “Euro deadbeats”, and exact non-financial costs, so the benefits of debt write-offs would be counterbalanced, at least in part, by new costs. There’d have to be some cost-benefit analysis. But the options are not, as Winecoff suggests, a zero-sum shift in how countries take their lumps. Countries may find they have a lot fewer lumps to take if they repudiate their debt than if they don’t.

It may not be zero-sum, but that doesn't imply that one option is obviously better. If you take your lumps and pay off your debt, you get rewarded by having access to international capital markets. This can boost investment and future growth, smooth future business cycles, etc. In the eurozone, it means a credible exchange rate and lower borrowing costs, as well as unfettered access to the world's biggest market. Over any medium- to long-run horizon, it is certainly possible, perhaps even likely, that you'd be better off. That's why I don't default on my credit card every month. If you default, you lose those benefits. No more external investment. No more smoothing the business cycle. Lower growth. And it takes a very long time to overcome a bad reputation. To say that "deadbeats just need to pay for what they buy now" misses the point: non-deadbeats could do that too, if they wanted. Defaulting removes the option. Everyone would rather have access to a credit stream than not.

Of course this is where we get into the distributional politics, which is where I wanted to be all along and where I got in my subsequent post on the Quiggin/Farrell article. Admittedly, I used some crude econ to get there, which is where SRW's corrections are useful. But what I really wanted to highlight was that this is a political choice, about who is going to bear the brunt of austerity. So I am befuddled when SRW says this:

Lots of countries, obviously emerging Asia but also Germany, seem to prefer the social goods that come with full employment and financial security to the consumer purchasing power gains that accompany current account deficits. The countries of the Eurozone periphery have so far “chosen” the path of excess consumption, but it’s not clear whether that represents a genuine preference or a historical accident.

Those countries, including Germany, have forced savings. Many emerging Asian economies have capital controls and/or unconvertible currencies. They are also poor and usually well below full employment. (Germany is only half-poor... the eastern half, and ran a CA deficit from reunification until recently. They also have high underemployment, and not especially low unemployment: "However, when comparing the rates of unused labour supply between EU countries, Germany (20.1%) ranks only 20th".). Meanwhile, before the crisis, Ireland and Iceland had full employment and high standards of living and (perceived) financial security.

So any way you strike it, default/devalue is a major step down. How far down, and who pays, is the only question remaining. But let's not kid ourselves... there's no technocratic solution to this. I'd put it much nearer to "catastrophe" than "bows and flows of angel's hair".


There Will Be Austerity




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