In the immediate aftermath of the 2008 banking crisis, with fiscal deficits soaring around the world, a term entered the popular lexicon: austerity. Evoking notions of responsibility and constraint, it quickly spread through the media.
The popular appeal of austerity is all about its intuitive narrative. Governments are supposed to be much like private companies or individuals: if they spend more than they earn, through debt financing, they will eventually face disaster. They will either become outright bankrupt, or the value of their bonds will fall, causing interest rates to rise. The state will face an unsustainable debt burden, which will reduce the prosperity of future generations.
A Generally Accepted Notion
Around the world, faced with this powerful and intuitively appealing argument, center-left parties fully accepted the need for fiscal contraction. Studies, like the now-infamous “This Time is Different” by Economists Carmen Reinhart and Ken Rogoff, were presented as empirical proof that there is no alternative to deficit reduction. The British Labour Party’s 2010 manifesto promised to halve Britain’s fiscal deficit by 2014. The French Socialist Party promised to eliminate France’s deficit by 2017.
These parties, which for decades have been split over the relative merits of modern neoliberal and traditional social democratic politics, were intellectually outgunned by the mainstream view, offering little resistance. In the aftermath of the crisis, they accepted the notion that the large Government deficits, and even the crisis itself, is the result of a recent increase in social welfare spending. In reality, at the start of the crisis, the UK government had close to its lowest net public debt relative to GDP in several hundred years. That ratio is still much lower than the long-term historical average.
There are an array of problems and fallacies inherent in this view of the economy. It is, first and foremost, a narrative that appeals to notions of moral responsibility. What is indeed clear is that in the run-up to the crisis, too much debt was being created. There is, however, a very important distinction to be made between government debt and private debt. UK government deficits were running at a perfectly modest level before the downturn.
The cause of the increased budget deficit was, above all, the proper functioning of the economy’s automatic stabilisers. When the full extent of the crisis became apparent in autumn 2008, housing and equity markets crashed. This wipeout of personal wealth caused a large decline in consumer spending, which in turn reduced firms’ profit expectations. Unable to finance their excess inventories, businesses cut capital spending and crucially, employment.
The effect of a major increase in unemployment on a government budget is twofold. Taxable income, and therefore tax revenues, decline, while at the same time, eligibility for unemployment benefits increases. This translates into sudden higher spending and less revenues, i.e., a larger deficit, with no change in government policy. As Martin Wolf, the FT’s chief economics commentator wrote on his blog in reference to the US:
“The idea that the huge fiscal deficits of recent years have been the result of decisions taken by the current administration is nonsense. No fiscal policy changes explain the collapse into massive fiscal deficit between 2007 and 2009 because there was none of any importance. The collapse is explained by the massive shift of the private sector from financial deficit into surplus or, in other words, from boom to bust.”
Many politicians and pundits have even hinted that the British government could actually face bankruptcy. In George Osborne’s 2010 budget speech, he warned that “you can see in Greece and example of a country that didn’t face up to its problems, and that’s a fate I am determined to avoid.” This view is fundamentally wrong. Its membership of the Eurozone monetary system puts Greece in an entirely different position to that of the UK, and to any currency issuer.
The Greeks Have Lost Control
The Greek Government has no control over its monetary policy. It has no central bank and is, therefore, operating much the same way that a private business operates. There is every possibility that Greece could default on its roughly €360bn of debt if its borrowing costs become unmanageable. Britain, on the other hand, is a Sovereign currency issuer.
Its debt is denominated in Sterling, of which it is the monopoly issuer. The Bank of England directly controls Britain’s cost of short-term borrowing, through its corridor-system.
The bankruptcy of a sovereign currency issuer, with its debt denominated in its own currency, is quite simply an impossibility. Of course, excessive inflation is possible if very high spending created excess aggregate demand for example, but solvency is in effect a non-issue.The rate floor is set by the interest paid on reserves and the reverse repo rate, while the ceiling is established by the bank rate or repo rate – the rate charged by the BoE on borrowed reserves.
The Bond Vigilantes
Britain’s cost of borrowing is at the lowest levels in history. Two-year bonds are yielding 0.13% as of late August 2016. Ten-year bonds are at just 0.55%. Some austerity advocates claim that these yields are actually the result of fiscal austerity. They warn of ‘bond vigilantes’ forcing up interest rates if ‘extravagant’ spending continues. All that is needed to dispel this view is a quick look at Japan’s fiscal position. The debt-to-GDP ratio stands at nearly 230%, compared to the UK’s ratio of just over 80%. If ‘bond vigilantes’ can actually control a sovereign currency issuer’s interest rates, then Japan’s cost of borrowing should be much higher than the UK’s.
The reality? Japanese two-year bonds are yielding negative 0.20%. Even it’s 30-year bonds yield just 0.32%. This is because in Fiat monetary systems, central banks, not markets, ultimately control interest rates. But this begs the question, why are Government borrowing costs actually lower than central banks’ target rates? The answer is fairly simple. The financial crisis of 2008 was, according to the then British Chancellor Alistair Darling, “probably the worst situation we’ve faced in peacetime.” Estimates vary, but a US Treasury Department assessment puts the total lost household wealth at $19.2trn.
The largest credit bubble in history began to burst in 2007 when US subprime mortgage default rates started to escalate. CDOs and other securitized debt products were created from risky ‘Ninja loans’ – loans made to borrowers with no income, no job and no assets. The contracts relied entirely on continued house price appreciation. These were pooled together by large banks and given triple-A credit ratings, before being sold off to investors, often pension funds restricted to triple-A securities, looking for higher yielding assets than treasuries. These “toxic assets” spread unchecked through the global economy, as credit rating agencies with heavy conflicts of interest labelled them as entirely safe.
The proliferation of unregulated OTC derivatives, namely credit default swaps, supposedly allowing firms to fully hedge their positions and thereby reducing systemic risk, led to the creation of even more complex credit derivatives, like synthetic CDOs, which further amplified the crisis. Paul Kanjorski, Democratic Congressman for Pennsylvania and former Chairman of the Capital Markets subcommittee, gave an account of events as given to him by then-Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke, on 18 September 2008:
“At 11 am, the Fed noticed a tremendous draw-down of money market accounts in the US; $550bn was being drawn out in the matter of an hour or two […] we were having an electronic run on the Banks […] (the Fed) decided to […] announce a guarantee of $250,000 per account […] If they had not done that, their estimation is that by 2 pm that afternoon, $5.5trn would have been drawn out of the money market system of the US; this would have collapsed the entire economy of the United States, and within 24 hours the world economy would have collapsed. It would have been the end of our economic and political system as we know it.”
Markets have not fully recovered. The enormous private deleveraging process that the collapse initiated has kept profits, and dividends suppressed. The low interest rate environment, required by the huge amounts of private debt, has kept yields on almost all assets low. In the low yield environment since the crisis, new types of financial instruments, such as ETFs, have exploded in popularity. But confidence has not returned to many markets, and this causes investors to rely on safe, reliable assets. As a result, the demand for the safest of all assets, government debt, has been very high, pushing up the bond prices, and therefore lowering the yields.
In other words, this unprecedentedly cheap cost of government borrowing is because of the fragility, uncertainty and sectoral surplus of the private sector. There has never been a more ideal time for governments to engage in renewed fiscal stimulus. Fiscal multipliers, the ratio of the change in national income to the change in government spending, were initially assumed to be 0.5, but even the IMF has been changing its stance in recent years. A 2012 report said that “our results indicate that multipliers have actually been in the 0.9 to 1.7 range since the great recession.” A 2013 paper by its then-Chief Economist, Olivier Blanchard, argued that “fiscal multipliers were substantially higher” than IMF models had first assumed.
“Forecasters significantly underestimated the increase in unemployment and the decline in domestic demand associated with fiscal consolidation”, the paper admitted. This is a key reason that Greek austerity measures have increased the nation’s debt-to-GDP ratio: the deficit reduction measures reduce GDP at a faster rate than they reduce sovereign debt. Those most in favour of austerity, due to their unshakeable neoliberal ideological position, can be found at the Bundesbank. They have a near-religious dislike of all things governmental. Some view the reduction of the state as the end goal, in and of itself, regardless of the economic outcome. Many EU politicians, like the president of the Eurogroup, Jeroen Dijsselbloem, share a similar market fundamentalism. But most proponents are not ideologues. They simply believed the persuasive case put forward in the crisis’ aftermath and have yet to change their minds.
The Balance Sheet Recession
The reality of what the world has been, and still is, experiencing, is what prominent economist Richard Koo famously called a “balance sheet recession.” In very simple terms, during the boom, assets of all classes were increasing in value. To profit from that increase in price, companies borrowed money in order to buy them and make a profit, becoming highly leveraged. When the crash occurred, assets held by these firms suddenly collapsed in value, while the value of their liabilities remained the same. This meant that many companies’ balance sheets became negative, otherwise known as bankruptcy, saddled with too much debt. In order to reduce this debt burden, companies and households reduce wages, investment and spending and redirect the money towards paying down their debt. As Koo points out, this behaviour is inconsistent with every business school course, which says that firms try to maximise profit at all times.
Instead, firms were minimising debt. On an individual level, this is the right thing to do. But what happens when everyone does this simultaneously? So company A reduces its spending, but this is the income of company B, which reduces its spending, which is the income of company C and so on. As all agents reduce their expenditure, all of their incomes fall as a result. The effect is that all private balance sheets contract together in lockstep. As more income is used for debt repayment rather than spending, income itself is reduced, which increases the debt burden, and a vicious cycle ensues. The only way this downward spiral can be stopped is if the government increases its budget deficit. The FT’s Chief economics commentator Martin Wolf puts it more simply: “austerity has failed, it turned a nascent recovery into stagnation.” The ideological deactivation of fiscal policy across the West has slowed and prevented many countries’ economies emerging fully from their post-2008 balance sheet recessions.
This links to an important concept: sectoral financial balances. This is a key macroeconomic accounting identity:
(I-S) + (G-T) + (X-M) = 0
I represents private investment, S private savings, G government spending, T taxes, X exports and M imports. This equation shows the financial balances of the economy’s three sectors. Here is a graphical representation:
Every financial asset has a corresponding financial liability. The equation can be rearranged to:
(S-I) = (G-T) + (X-M)
In other words, the private sector surplus (the net savings) is equal to the public sector deficit plus the current account surplus. Therefore, if the private sector is to recover and reduce its debt by running a surplus of a certain amount, either the public sector or the foreign sector (or both) has to run a deficit of exactly that amount. What this means is that in a period of private sector deleveraging, if the government is to run a balanced budget, then the trade deficit must rise to exactly the size of the private surplus. As Martin Wolf put it:
“The shift by households towards greater surpluses was the biggest cause of the collapse in the economy […] If governments want to cut their deficits, other sectors must, in aggregate slash their surpluses […] there are two ways such an adjustment can happen: higher spending, at given incomes, or a collapse in incomes. When interest rates are low and the financial sector frozen, the latter is far more likely than the former. In other words, the adjustment to fiscal austerity occurs via a slump.”
On August 4th, in response to the Brexit vote’s effect on UK market confidence, the Monetary Policy Committee announced a cut in its bank rate from 0.5% to 0.25%, alongside a £60bn round of Quantitative Easing. This same policy response in 2009/2010 provoked widespread fears of high inflation. It was routinely referred to as ‘printing money’ on talk shows like the BBC’s Question Time.
Fox News and CNBC pundits have railed endlessly about ‘debt monetization’, money printing and comparisons to Zimbabwe or Weimar Germany. George Osborne said in 2009 “printing money is the last resort of desperate governments.” Art Laffer, one of Reagan’s economic advisors, said that “the expansion of money, given an increase in the monetary base, is inevitable, and will ultimately result in higher inflation and interest rates.” These are examples of highly confused understandings of quantitative easing (QE).
Liquidity Vs Capital
In reality, the huge increase in the monetary base did not cause inflation because it is essentially an asset swap. Whilst QE does entail the ‘printing’ of new central bank reserves, it also involves the effective ‘unprinting’ of government bonds of the same value. The central bank is merely changing the composition of private sector balance sheets, particularly those of investment funds. The private sector’s net worth is unchanged, as it is injecting liquidity, not capital. It is simply replacing one private sector asset (a government liability) with another (a central bank liability). In theory, it will help the economy by encouraging asset managers, who now have deposits instead of Government bonds, to purchase other financial assets such as corporate shares and especially bonds.
This increased demand for bonds drives up their price, lowering their yields, making it cheaper for companies to borrow money and hopefully stimulating private sector growth. The argument from some has been that although the UK government’s austerity program clearly damages growth, its effect can be mostly mitigated by this ultra-loose and unconventional monetary policy. QE has actually had very little effect on GDP, because unlike fiscal stimulus, it doesn’t increase aggregate demand. Its effects are upon confidence, specific interest rates, and certain asset prices. The first round of QE was unique and almost certainly beneficial because it was focused on purchasing mortgage-backed securities (MBS), rather than government bonds. It helped to stabilise the American MBS market at the height of the panic in late 2008, giving some breathing room to banks around the world.
Plans For The Future
The post-Brexit Conservative government led by Theresa May has signalled that it plans to temper its deficit reduction measures. This is undoubtedly positive, and with a sizeable budget deficit remaining, it is also implicitly an admittance that for more than five years, the Government’s central policy has been guided by a deep economic illiteracy, and whilst the Chancellor Phillip Hammond will not verbalise this anytime soon, the debate is largely over, and the tide does appear to be shifting. In the words of the IMF’s research department deputy director, J. Ostry:
“Cultures are slow moving things […] There are a lot of people thinking the same thing at this point, that basically some aspects of the neoliberal agenda probably need a rethink”.
What is clear is that central banks alone cannot revive a strong growth pattern and that large, sustained and long term Government investment is desperately required across the advanced economies. Austerity might, for a while, remain the official policy in Western economies, if for no other reason than the inability of many politicians to admit that they have been so fundamentally wrong for so long, and have needlessly impoverished so many along the way. But even on the center-right, the cracks are beginning to show. Donald Trump, with remarks like “they want to cut your social security, I’m not cutting your social security” appears to signal a break from Republican economic orthodoxy. He does have some very strange views about the way the economy works, but his heresy on this issue is still a refreshing, if somewhat perplexing, development.