independent

Saturday 19 April 2014

As the salt pillars of austerity crumble there will be enormous opportunities

THE forces of austerity are in retreat all around Europe and the world. Let's make no mistake about what this means. The word 'austerity' has come to mean many things, but austerity is shorthand for the European policy of lumbering citizens with the debts of the financial markets and contending that the resulting increase in the national debts is the cause of the problem, rather than the consequence.

Then, in order to heighten people's anxiety, the policymakers continued to genuflect to the financial markets' verdict about the policy when it was financial market unsustainability via excessive lending that caused the problem in the first place.

Obviously not all the increase in the national debt has been due to the transfer of money from the citizen to the speculator; a significant amount of the debt problem is the consequence of the crash itself and the impact of the crash on people's balance sheets.

When assets collapse at a time of high debts, four separate but linked things happen which propel the economy on a negative trajectory.

First, the balance sheet of the broad middle breaks apart. This is because the "assets" of the middle class – houses, apartments and land – collapse in value. So the asset side of the balance sheet shrinks. In contrast, the liability side of the balance sheet expands because it is weighed down by the debt that was taken to buy those assets. How many people do you know who are in that situation right now? Another term for this is negative equity.

Second, resulting from the broken balance sheet, people are worried about the future. This means that even those people who have money and an income save. Those without savings and whose income is under pressure try to pay their debt back. All this means domestic demand is punctured. Retail sales drop and spending falls.

Then something odd happens: retailers respond by cutting prices. But when people who are worried see prices falling, rather than conclude that there is a bargain to be picked up, they conclude that prices will fall further, so they actually spend less. We are witnessing this in the retail carnage in Ireland at the moment.

The third development associated with the collapse in asset prices is that interest rates don't work. It doesn't matter how low interest rates are, people have too much debt and they don't want to borrow and the banks have too much bad debt and they don't want to lend. So money gets stuck in the banking system.

The fourth thing is that the "paradox of aggregation" takes hold. The banks tell the customer to sell their asset to recoup losses. This sounds sensible, doesn't it? But it is only sensible if one person sells and everyone else buys. But what do you think happens if everyone is told to sell their assets at the same time? Obviously, asset prices will fall rapidly and while the debt remains the same, the paradox is that the person who tries to pay down debt quickest gets into more debt.

So the upshot of all this is that the savings ratio of the country rises rapidly and tax revenues fall. This causes the budget deficit to rise because the Government has little choice but to try to maintain demand in the face of the quadruple whammy to the economy. If it can't sustain demand from tax revenues, it borrows the money and the national debt rises.

So you can see that the budget deficit and the national debt increase are the consequence of the downturn not the cause.

However, somewhere along the way 'conventional wisdom' decided that the analysis worked the other way and that the national debt and the budget deficit were the cause of the problem. So we get the policy of reducing the budget deficit at all costs.

Anyone with a brain can see that if you cut government expenditure the economy will slow and poor people will be hit hardest because they are most dependent on the State for income.

Taking a bit of altitude, when interest rates are 1pc in Europe and unemployment is 25 million, there is no demand for capital and there's a massive excessive supply of labour. That's what Leaving Cert economics would tell you.

But even in the face of reality, the proponents of austerity had to come up with a faux theory as to why austerity was necessary. The main plank of this was research by two economists from Harvard, Ken Rogoff and Carmen Reinhardt, who came up with research saying that historical data indicates that when debt-to-GDP ratios rise over 90pc, the economy of the country falls. This was taken as gospel until last week when other economists looking at the same data proved that Rogoff and Reinhardt had made some elementary statistical mistakes and there was precious little evidence to indicate that a certain national debt figure triggered economic Armageddon.

The IMF has been making squeamish noises of late as they see European growth plummet, unemployment rise and income fall.

Now that the intellectual pillars of austerity are seen to be made of salt, the politicians are jumping ship. Jose Manuel Barroso, the boss of the EU Commission, has said that austerity may be reaching its limits.

Even Michael Noonan, a supporter up until yesterday, has had a volte face extraordinaire and is now saying that the Irish presidency has been working tirelessly to dismantle austerity behind the scenes. This is obviously why the Irish presidency oversaw the austerity-driven shambles in Cyprus two weeks ago!

If the policy is abandoned, you can look forward to relaxed budget constraints, some tax cuts and possibly even spending increases on public infrastructure. The debt burden will have to be kicked out for many years. Given that any relaxation of austerity in Europe would force interest rates up, there is a debt tsunami in the guise of defaulted tracker debt coming down the road. Now would be a good time for the Government to try to get a deal on mortgage debt.

If austerity crumbles, all bets are off, new deals will be signed and the old rules will be thrown out. This is an enormous opportunity. Ardent supporters of austerity, like ardent communists turned capitalists in Russia, will embrace the new reality. The King is dead. Long live the King!

Irish Independent

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