Strangulation Economics

Europe Chooses Depression
By MIKE WHITNEY

Forget about a smooth recovery. Finance ministers and central bank governors of the G-20, met this weekend in Busan, South Korea and decided to substitute "tried and true" expansionary fiscal policies for their own strange brew of belt-tightening and austerity measures. The EU members are eager to restore the illusory "confidence of the markets", something that will surely be lost when the eurozone slides back into recession and the hobbled banking sector begins hemorrhaging red ink. Trimming deficits while the economy is still on the mend will weaken demand and force businesses to lay off more workers. That will decrease economic activity and slow growth. It's a prescription for disaster.

Here's the final paragraph from the G 20 communique:

“The recent events highlight the importance of sustainable public finances and the need for our countries to put in place credible, growth-friendly measures, to deliver fiscal sustainability, differentiated for and tailored to national circumstances. Those countries with serious fiscal challenges need to accelerate the pace of consolidation. We welcome the recent announcements by some countries to reduce their deficits in 2010 and strengthen their fiscal frameworks and institutions. Within their capacity, countries will expand domestic sources of growth, while maintaining macroeconomic stability."

EU finance ministers show that they still do not understand the origins of the credit bubble that triggered the financial crisis and subsequent recession. Greek bonds are no more to blame than subprime loans. When banks issue loans or purchase bonds it is incumbent on the lender to do due diligence and to check the creditworthiness of the borrower. Traditionally, banks have been very good at getting their money back because they have followed standardized procedures. The rise of shadow banking changed all that.

Securitization and repo market transactions create powerful incentives for repackaging dodgy loans so banks can heap huge amounts of leverage atop bad paper. The quality of the loan no longer matters. EU leaders believe the problem can be solved by gutting social programs and strangling the unions, but this misses the point entirely. The shadow system has to be strictly regulated so the threat of credit bubbles is minimized.

U.C. Berkeley economist Brad DeLong explains what the EU should be doing in his article "We Need Bigger Deficits Now":

"It is a time for not normal economics but rather “depression economics.”...Normally, only government spending initiatives or tax cuts that promise a high value for the dollar are worth undertaking, but things are different now... an increase in federal spending or a cut in taxes will produce (in the short run) no increase in interest rates and hence no crowding-out of productivity-increasing private investment. Indeed, government spending that adds to firms’ current cash flow may well boost private investment and so leave us, dollar for dollar, richer after the effect of the stimulus ebbs.....Thus it is a no-brainer that we ought to be doing more fiscal stimulus." (Brad DeLong, "We Need bigger Deficits Now", Economist's View)

The same rule applies to the EU as to the US. Spending increases aggregate demand and grows the economy. When the private sector is too far in debt to narrow the output gap and reduce unemployment, the government has to pick up the slack. Fiscal stimulus cuts the deficits by generating more government revenue. People mistakenly believe that deficits are increased by wasteful government spending, but that's not the case. Deficits widen when revenues plunge because economic activity slumps as it does during a severe recession. The sensible way to trim the deficits is to spend money on the front end and put the country back to work. This is not "liberalism" or "Keynesianism"; it's common sense.

By refusing to provide more fiscal stimulus, Europe is marching headlong into a depression. State funding for additional stimulus is blocked by higher bond yields in the Club Med countries. This is completely unnecessary. The ECB can buy up bonds and force yields down increasing the flow of cash to the weaker economies so they can grow their way out of recession. Instead, the EMU--led by Germany--has chosen hairshirts and thin gruel; a protracted slump and needless suffering brought on by a bizarre attachment to bonehead economic theory. The "market" is not stopping the EU from growing its way out of recession. That's the work of policymakers who want to stuff the 16-state union into a fiscal straightjacket so they can crush the social model that supports workers benefits, rights and entitlements. This isn't economics; it's class warfare.

When GDP shrinks--as it inevitably will--the deficits will grow, public confidence will wane, relations between member states will sour, and cities will fill with angry demonstrators. Fiscal consolidation will trigger a crisis bigger than Lehman Bros. The ECB needs to support demand by encouraging government spending while households patch their balance sheets and regulators take over underwater banks. Any deviation from this plan will only exacerbate the problems.

European banks have dug themselves a $2.6 trillion hole (according to the New York Times) They are on the hook for roughly $500 billion in bonds from Greece, Spain and Portugal--all of which have been downgraded. And they've loaned another $1.5 trillion to other EU banks and (shadow) non-banks, much of which will eventually have to be written down.

This shows that the real problem is the banks, not sovereign bonds. The EU is faced with the same problem as the US; either take over insolvent banks and restructure their debt--making bondholders and equity holders take a haircut--or endure years of hellish subpar economic performance with high unemployment, dwindling investment, grinding deflation and social unrest. The EU has chosen the latter, and for good reason. A cheaper euro makes EU exports more competitive, which will keep the EU's most powerful member (Germany) happy. Also, deflationary policies protect the interests of bondholders who are heavily invested in financial institutions whose asset values are grossly inflated by cheap money and massive leverage. Finally, austerity measures transfer the losses from banks and shadow banks onto the backs of workers, consumers and retirees. "Screwing workers" drives policy in the EU much as it does in the US.

Belt-tightening in the EU means that the world will (again) have to rely on the US consumer to bounce back, shrug off his historic burden of personal debt, and resume spending like a madman. With unemployment hovering at 10%, credit lines being slashed by the day, and retirement just around the corner (for many baby boomers); that seems like an unlikely prospect.