independent

Thursday 17 April 2014

Stephen Kinsella: EU version of our crisis is totally wrong and must be challenged

I WANT you to imagine a little toy economy to help us think through the problems of austerity and debt relief. Telling the right story matters when dealing with the European authorities, because they have their own stories about us. We can use our story, rooted in reality, to combat theirs. Stay with me for the next few paragraphs and we'll get somewhere interesting, I promise.

Imagine an economy with no inflation problem – prices go up by 2pc a year – and no problem trading with the rest of the world, the difference between the value of its imports and its exports is nearly zero.

The country is in a lot of debt. It borrowed heavily from the rest of the world in past years. Imagine there's a large increase in government spending in this little economy, and everyone regards the increase as a permanent one. The increase in government spending comes from borrowing.

The increase in demand for goods and services caused by the increase in government spending leads to an increase in the value of output. Taxes rise automatically in line with the rise in output.

In something amounting to a macroeconomic miracle, the increase in taxes can be enough to halt government borrowing and stabilise the amount of debt the government is running up.

Two problems now present themselves.

If inflation starts to get out of hand – because everyone is throwing around the government's borrowed money like snuff at a wake causing prices to rise – then the government will have to stop its expansion of spending, or it will wipe out everyone's savings and hammer the poor, the sick and the old, on fixed incomes.

Worse, if the country is very open, and can trade with the rest of the world, but the rest of the world is going into a recession, then the government's debt will explode because there won't be enough domestic spending to produce enough tax revenue to stabilise the government's debt.

The government is caught. It can't go on a spending spree, no matter how much it would like to. It has to control spending – implying some austerity – but it also needs either to grow by increasing the value of its output, or reduce the ratio of its debt to its output by reducing the level of debt it holds to have a sustainable level of debt.

Debt is a contract. In our little economy, the counterpart to expanding government debt will be an expansion of the debt the country owes to foreigners. Our debt is also theirs, in a sense. And in the real world, we have a lot of debt in Ireland.

Ireland is trying hard to get its debt levels under control by controlling government spending, reducing the negative balance between government spending and government income from taxes, and by renegotiating the bank-related debt with the European authorities.

The European authorities may claim that Ireland's problem is home-grown, and ignored by the Irish authorities, particularly the regulator, and so the solution should be Irish, with Ireland's taxpayers taking the pain.

This view ignores the fact that the Irish banks were lent huge sums of cheap money at low rates by German and French banks, which allowed Irish households to buy French and German products, pushing the difference between our imports and exports highly negative, and theirs highly positive.

They benefited from the Irish boom, their banking systems benefited from the Irish rescue of Ireland's banks, because the systems are so interconnected.

The European authorities may claim that two 'Irish' banks, Depfa and Phoenix, which were subsidiaries of HypoRealEstate and the WestLB, lost heavily because of their exposure to Ireland, and had to be nationalised by German taxpayers who took the hit for their banks' failures. In the mouth of a national election, forcing German taxpayers to bail out profligate banks is simply impossible.

This narrative is completely wrong. The banks lost heavily not because they over-extended themselves but because they poured their dodgiest loans and derivative structures into their Irish subsidiaries. They used Ireland's lax regulatory environment for their own gain, and, unregulated by either Dublin or Berlin, blew themselves up.

The European authorities may claim the UK has no commitment to putting money into the European Stability Mechanism, a huge bailout fund set up by the European authorities.

UK banks and the UK taxpayer would benefit disproportionately if Ireland got a deal on its debt. This is true. And so what? If the UK receives a boost on the back of an EU action, and it grows as a result, surely that benefits the European Union in the long run?

The European authorities might claim that Ireland is a rich country with high political stability and a functioning governmental system. The level of 'sustainable' debt is much higher for Ireland than for Greece. This is true, but the longer austerity policies remain in place, the more likely social and political instability will happen.

In 1931 the great economist John Maynard Keynes wrote "if we consistently act on the optimistic hypothesis, this hypothesis will tend to be realised; whilst by acting on the pessimistic hypothesis we can keep ourselves forever in the pit of want."

We can change the story we tell ourselves and the European authorities. We can fight their story with ours, and we can win a better future with it.

Stephen Kinsella is a Lecturer in Economics at the University of Limerick

Irish Independent

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