Tuesday, May 28, 2013

Too little, too late, EU remains on the wrong track


In its annual verdict on national budgets of all 27 EU members France, 
Spain and the Netherlands will be given a waiver on the annual 3 per cent deficit limit. Brussels will also free Italy from intensive fiscal monitoring despite its new prime minister’s decision to reverse a series of tax increases imposed by his predecessor. EU eases hard line on austerity.
(Spiegel, 2103)

This is fine but ultimately theatrics. Europe's policy makers have enabled an initial recession --that was triggered by the irresponsibility of the continent's banking sector-- to turn into a depression all for the ostensible purpose of adherence to a sound finance regime that was consistent with the Maastricht Treaty. We see the result in the massive unemployment numbers, particularly amongst youth in the periphery.
Policy prescriptions that wish to mimic the austerity experience of Canada in the 1990s would do well to remember the following:

Is there a flexible exchange rate to help with adjustments?
See how the Canadian dollar fared with the US dollar during the period 1990-2003.

Is your main trading partner growing?
After the downturn at the end of the G.H.W. Bush era the United States experienced strong growth during the Clinton terms, enabled in no small part by the flood of capital to replenish the nation's fixed capital stock during what would be called the tech boom.

How is your main trading partner's labour market?
Robust in the case of the United States during Canada's austerity drive (see the line representing Clinton).

How is your main trading partner's fiscal house?
National debt as a percentage of GDP improved during the two Clinton terms.
Austerity is tough medicine but for a small open economy like Canada's it was made possible thanks to external factors. The biggest factor being that its main trading partner, the United States, was in a healthy situation and the destination for its exports and Canada was able to depreciate its way to growth with the CADUSD exchange rate hitting 0.63 in 2003. Concurrently, the following happened below:
Canada's Balance of Trade (1990-2003)

Canadian GDP growth rate --note that it improved but is markedly lower than that of the United States (above)
Government Debt to GDP peaked in the mid 1990s to come down once growth was re-established.
Federal Budgetary Balance: Government had its fiscal house 'in order' so to speak by the turn of the century.
None of this will happen in the Eurozone. The peripheral nations have been sent to purgatory with little hope of emancipation; those wishing for structural reform as a result of the troika's edicts fail to recognize that such reform is an issue of political economy that the sovereign nation's body politic must come to grips with --it isn't something that will be solved by narrowly restrictive policy tools.

I will use Rob Parenteau's words to sum up as he was one of the original analysts who warned of the dire consequences of austerian policies (the full deck can be downloaded from this page).

The Eurozone Predicament: 3 Policy Strait jackets and Market Fundamentalism
  • Common currency means varying nominal exchange rate is not available to any one nation
  • Fiscal policy is subject to 3% fiscal deficit floor with fines
  • Monetary policy is subject to one size fits all committee
  • Burden of adjustment is largely shifted onto relative prices, private income deflation, and product innovation
  • Because markets are presumed to gravitate to full employment, utility maximizing equilibrium best on their own, undistorted by "artificial" policy interventions
  • If you rapidly reduce fiscal deficits in eurozone, you will also reduce private sector net saving
  • More difficult for private sector to service and reduce debt
  • Quest for fiscal sustainability in eurozone implies bank risk higher than government risk as private loans sour
  • Unless maxi-depreciation can produce large increase in trade balance for region as a whole, otherwise:
    • Peripheral eurozone trade balance swing tips up German , Dutch exporters unless new markets found

Parenteau's Key Takeaways:
  • If the current account is in deficit, and exchange rate policy is constrained, the private sector is more likely to be placed on a route to financial fragility and instability
  • The domestic private and government sectors cannot deleverage at the same time without a large, sustained increase in the trade (or current account) balance
  • Since European banks are more highly leveraged, the pursuit of fiscal sustainability may prove unsustainable if it lead to more private debt distress and bank losses.

References:
Spiegel, Peter. "EU eases hard line on austerity." Financial Times, Online edition, sec. Europe, May 28, 2013. http://www.ft.com/intl/cms/s/0/22348284-c7a6-11e2-be27-00144feab7de.html
Thompson, . "Europe's Record Youth Unemployment: The Scariest Graph in the World Just Got Scarier." The Atlantic, May 05, 2013. http://m.theatlantic.com/business/archive/2013/05/europes-record-youth-unemployment-the-scariest-graph-in-the-world-just-got-scarier/276423/ (accessed June 3, 2013).
Parenteau, Rob. "Minsky & the Eurozone Predicament: Transcending the Dismal Science." April 14-16, 2010. http://www.levyinstitute.org/conferences/minsky2010/