Saturday 23 February 2019

Constantin Gurdgiev: The real reason why austerity has failed

No one can defend the waste of resources implied by transfers from taxpayers to the insolvent banks

Constantin Gurdgiev

RECENT months have not been kind to the supporters of the theory of expansionary fiscal contraction – the core idea behind what we popularly term austerity.

Some six months back, the IMF published a paper that marked a remarkable U-turn in the Fund's assessment of the Troika policies in 'peripheral' Europe. While surprising to many journalists and the general public, the Fund's claim that European austerity was overdone and is damaging to the national economies was hardly a real shocker.

Since its foundation, the IMF had always relied on a policies mix for dealing with crises. These include sharp currency devaluations, and structured defaults on private and even public debt, designed to lower the burden of deflationary budget cuts and tax increases. Even with little transparency around the events shaping the euro area periphery bailouts, it is clear that the Fund pushed for more aggressive use of monetary policy and financial burden-sharing tools in Europe since the beginning. The ECB resisting this forced more adjustment burden to fall onto the shoulders of the real economy.

The IMF 'turnaround' of late 2012 was followed last week by the dramatic statement from Prof Ashoka Mody. One of the principal players in structuring the Irish bailout of 2010, Prof Mody claimed that austerity measures imposed on Ireland and Portugal were counterproductive and that Ireland could have been better served by imposing haircuts on banks and sovereign bondholders.

If these two events were not enough to stir popular discontent with austerity policies, last week's very public challenge to the intellectual foundations behind austerity will. In an academic paper, published this month, a group of researchers from the University of Massachusetts, Amherst, have uncovered serious computational and methodological errors in the seminal study by Carmen Reinhart and Kenneth Rogoff published three years ago that quantified a strong relationship between high public debt and lower economic growth. The fact that a number of other studies have independently confirmed said link, based on different data sources and methodologies, seemed to have escaped the proponents of uber-Keynesian doctrine of curing the debt crises by accumulating even more debt.

Alas, the latest iteration in the economic policy debate is about as productive as the original fallacy of euro area-styled austerity.

Latest data from the IMF, released last week, shows that based on budgetary projections, euro area general government expenditure will rise 14.1 per cent on 2007 levels in 2013. Of all euro area member states, Greece stands as the only country where government spending in absolute terms will be lower in 2013 than it was in the last pre-crisis year.

Let's compare the 2000-2006 period of pre-crisis excesses that accompanied boom years against the 2007-2013 period that includes the period of 'savage austerity'. Cumulative government deficits over the 2007-2013 period across the euro area are forecast to add up to €2,389bn, with €1,229bn accruing to the euro area periphery. In contrast, during the 2000-2006 period, cumulative deficits stood at €1,148bn for the euro area, and €386bn for the euro periphery. Put differently, during the crisis, public deficits doubled, on a cumulated basis, across the euro area as a whole, and rose three-fold across the periphery. In the case of Ireland, the swing from the pre-crisis period surpluses to the crisis period deficit financing amounts to 110 per cent of the 2012 GNP.

These figures clearly show that any harmful effects of the austerity on the euro area and Irish economies did not come from the reduction in the levels of expenditure. Instead, the real harm was caused by the nature of the internal devaluation policies chosen and the lack of monetary policy support.

Most of the fiscal adjustment to date in Ireland and elsewhere across Europe took the form of tax increases and shifting of the costs of public services onto the shoulders of consumers via increased charges, fees and State-controlled prices.

In addition, much of the public spending increases during the crisis years have been consumed, especially in countries like Ireland, by transfers from taxpayers to the collapsed banking systems. Unlike a straight reduction in public spending, such measures not only reduced domestic demand, but also lowered private investment and helped trigger precautionary savings, while slowing down the process of debt deleveraging among households and non-financial corporations.

The key point here is that absent 'bail-ins' of banks' bondholders and actual level reductions in public spending, the austerity we have experienced has been nothing less than a misallocation of scarce economic resources from productive sectors (households, value-adding public services and investment, and non-financial corporations) to unproductive ones (banks, the broader financial system, protected areas of the public sector, and social welfare).

While one can make a strong case for the need to sustain social welfare spending during the crisis, no one can defend the waste of resources implied by transfers from the taxpayers to the insolvent banks.

This point is made clear by the evidence published in the IMF's Global Financial Stability Report also released last week. The report shows unequivocally that after massive injections of taxpayers' funds, Irish banks remain bankrupt and dysfunctional appendages of the State. Current IMF systemic risks indicators rank the Irish banking system as the second sickest in the common currency area after Greece, which is yet to undertake full recapitalisation and reforms exercises.

Spain – a fellow peripheral state that is yet to complete restructuring of its banks – ranks well ahead of Ireland in terms of its financial sector stability.

In short, recent evidence on failures of the austerity model in Europe says far less about the overall merits or costs of the policy push to control runaway public deficits and more about the mix of policies deployed.

European economic policy to date has been focused on persistent and consistent push of public and financial sector liabilities onto the shoulders of households and non-financial companies. The correct path, as I have argued since the beginning of the crisis, would have been first imposing the burden of the crisis onto the shoulders of lenders and other financial investors in the banking sector, followed by a more gradual, structural and deep reforms of the public expenditure and services provision, supported by more aggressive monetary policy bypassing the broken banking sector to inject liquidity directly into the euro area economies, while minimising the impact of austerity on those in need and taxpayers in general.

Irish Independent

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