David McWilliams Explains Why Austerity Is Doomed In Europe

A very interesting video by an Irish economist explaining how the current reduce government spending (“austerity”) approach to the Eurozone debt and currency crisis is doomed to fail. It is doomed because cutting government spending in a recession only makes the recession worse, which in turn, reduces tax collections which then makes the government deficits worse not better.  But not only is the austerity approach all wrong to solving the debt crisis, it carries very significant risk of social upheaval.  (hat tip to Philip Pilkington and New Economic Perspectives).

Now I’ll offer one pre-emptive comment.  Critics of the arguments McWilliams makes often claim that either government spending isn’t really effective, that somehow only private investment spending will stimulate an economy.  Or, the critics claim that any resources the government puts into use through spending actually detract from the economy by denying those resources to some supposedly better, privately chosen use. Both of these criticism fail.  We are clearly discussing a situation in which there are excess, unused economic resources in the economy.  In plain language:  there’s high unemployment and people are out of work.  The criticisms are all based on an idea called “crowding out”.  For crowding out to occur, the economy must be at full employment – the opposite of being in a recession.

Warning: More Bank Bailouts Possible

One area I haven’t commented on much is the ongoing European “debt crisis”.  The Greek debt crisis is a part of it, but it’s only the tip of the iceberg.  The roots are much deeper.  One reason I haven’t commented is because it’s fairly complex and requires a lot of background explanation which I haven’t had time to write.  Nonetheless, it’s something worth mentioning.  In particular because it’s likely to mean more big bank bailouts.

In short, the crisis involves the way the Euro currency zone is constructed.  Countries that use the Euro have surrendered their sovereignty on monetary policy – that’s now the purview of the European Central Bank (ECB).  This means that government debt levels do matter for countries in the Euro.  They can default because they don’t have control over their own currency.  The U.S., Japan, UK, Canada, Australia, and others can’t default because they control their own central bank and currency.  But Euro countries can.  In the case of Greece and Ireland this means a high likelihood of default.  When the global economy crashed three years ago, it sent the economies of most countries down.  This raised the debt-to-GDP level by reducing the denominator, the GDP number.  But a country in a recession needs to increase government spending and deficits to stimulate growth.  Instead, the construction of the Euro agreement and pressures from the ECB forced these countries to pursue an austerity-based policy of cutting government programs.  But the cutting of government spending has only worsened the recession and shrunk their GDP even more, reducing tax collections.  It’s made default more likely.

In the Greek case, default appears inevitable.  The question is how much of a loss do bondholders take and when.  Therein lies a problem.  The people who own the Greek debt are largely big French and German banks. These banks themselves aren’t exactly robust.   If Greece defaults at a level that will actually help Greece find it’s way out instead of simply delaying the crisis, then these banks will likely take very heavy losses.  The losses are large enough to jeopardize the solvency of the banks themselves.  So Greek default also means figuring out how to recapitalize these big banks.  These are so-called “too big to fail banks”.

Currently there are negotiations going on about how to structure a  Greek default, simultaneously prop up the Euro banks, and stop a possible contagion effect from spreading to Ireland, Portugal, Spain, Italy, and Belgium.  But there have been negotiations over this crisis for nearly two years now with much successs.  The German and French leaders have promised a comprehensive solution later this week. It was supposed to be today, but it’s been delayed to mid-week.

What does that have to do with the U.S.?  Nobody really knows.  The devil is in the details.  At first pass, big U.S. banks aren’t supposed to have much exposure to Greek debt, so they shouldn’t be endangered by a large Greek default.  But, the big U.S. banks like Citi, JP Morgan Chase, BofA, and Goldman Sachs have large stakes in the big Euro banks.  A failed Euro bank could have repercussions.  Of greater concern are derivatives, particularly Credit Default Swaps. The U.S. banks, particularly Goldman are known to have been active in selling these derivatives.  Since the derivative markets and positions are largely secret and non-transparent (a failure of the Dodd-Frank Financial Reform bill), we don’t know if a Greek default will trigger significant liabilities for these banks.

In separate news, Bank of America, is on a death-watch by some analysts.  Yves Smith at Naked Capitalism clues us in:

If you have any doubt that Bank of America is in trouble, this development should settle it. I’m late to this important story broken this morning by Bob Ivry of Bloomberg, but both Bill Black (who I interviewed just now) and I see this as a desperate (or at the very best, remarkably inept) move by Bank of America’s management.

The short form via Bloomberg:

Bank of America Corp. (BAC), hit by a credit downgrade last month, has moved derivatives from its Merrill Lynch unit to a subsidiary flush with insured deposits, according to people with direct knowledge of the situation…

Bank of America’s holding company — the parent of both the retail bank and the Merrill Lynch securities unit — held almost $75 trillion of derivatives at the end of June, according to data compiled by the OCC. About $53 trillion, or 71 percent, were within Bank of America NA, according to the data, which represent the notional values of the trades.

That compares with JPMorgan’s deposit-taking entity, JPMorgan Chase Bank NA, which contained 99 percent of the New York-based firm’s $79 trillion of notional derivatives, the OCC data show.

Now you would expect this move to be driven by adverse selection, that it, that BofA would move its WORST derivatives, that is, the ones that were riskiest or otherwise had high collateral posting requirements, to the sub. Bill Black confirmed that even though the details were sketchy, this is precisely what took place.

Part of BofA’s problems, well, actually a very large part of it’s problems stem from the loose and possibly illegal banking practices at Countrywide Mortgage which it took over in 2008.  Yves updates us on this here.

Bottom-line on all this:  expect more big bank bailouts of some kind in coming months.  It might only be big Euro banks.  It might only involve Bank of America.  But there’s significant,if less than probable, chance that we’ll have to see another round of bank bailouts.

The Market Shrugs Off Rating Downgrade, Market Is Worried About Real Economy.

It’s now Monday morning, Aug 8.  It’s been roughly 60 hours since S&P downgraded the rating on U.S. government bonds.  In that 60 hours the media, particularly TV talking head channels, have been breathlessly awaiting what they felt was a certain market panic on Monday. Clearly interest rates would go up they said.

They were wrong.  The early results are in.   U.S. government bond prices have  gone up this morning!  That means government bond yields (interest rates) have actually gone down!  The 10 year bond actually dropped from 2.6% yield on Friday’s close to 2.48% at 9:30 am ET on Monday.

It’s really no surprise if you pay attention to real economic events and not listen to the TV media types who think talking in serious tones is a substitute for actually understanding economics.  First, serious investors, the ones who vote with their money in the market already know everything that S&P knows.  In fact, they know S&P has a really bad track record. So the rating doesn’t mean much to them.

What does matter is what choices or alternatives they have for investing their money.  Right now, the signs from the real economy in both the U.S. and Europe are grim.  Europe is struggling to achieve any growth outside Germany with several major economies actually declining due to their governments’ embrace of budgetary austerity.  The U.K. is on the ragged edge of another recession, again due to government cutbacks. The U.S. is barely registering postive growth with only 0.8% growth rate in the first half of 2011.  It’s clear, too, from the debt ceiling debate that the U.S. won’t be seeing much stimulus anytime soon and likely will join the Europeans in austerity budget cutting. Cutting that will only slow the economy further and possibly drive another recession.  So what theses investors know is that economic growth isn’t likely and that’s bad for stocks.  Stock markets aren’t the place to be now.

Further, Europe is continuing it’s slow-motion debt default crisis issues.  In the past week or so the crisis has spread beyond Greece, Ireland, and Portugal. Now it’s Italy and Spain too.  Even AAA-rated France is finding it’s bonds trading at significantly raised interest rates.  Now the debt crises in Europe are real problems because the nations inside the Euro zone don’t have control over their own currency, they don’t have a central bank, and they borrow in some other currency (Euro) rather than one of their own.  This is unlike the U.S.  The problem is the uncertainty the debt crises in Europe are creating.  The global financial and economic system is once again showing great signs of weakness, fragility, and uncertainty – just like 2007 and 2008.

When uncertainty abounds and about the only sure thing is that growth will be weak at best, it’s time to put your money in something safe and wait it out.  The safest thing in the world (in any volume) is still U.S. government bonds.  So what we have is investors moving into U.S. government bonds because they don’t want to be in anything else.  Everything else is too risky.  So we get increased demand for U.S. bonds and that lowers interest rates on those bonds. This is what financial analysts and economists call a “flight to safety”.

Ireland: “Responsible” Policy Punishes Citizens for Bankers’ Sins

Poor Ireland.  For some unknown reason, the Irish seem doomed to suffer under the misguided rule of others, despite being the source of great music, culture and a brew so good      For centuries, the oppressor was the English.  In this century Ireland has fallen under the boot of the bankers and The Powers That Be (TPTB) who have have fallen under the sway of “responsbile austerity”.  There is a lesson here for America if we would only listen and pay attention.

Earlier in this century, before 2007, Ireland apparently had left it’s history of poverty and oppression to become the poster child for success via globalization. It’s GDP boomed (see graph). It attracted foreign direct investment and many foreign firms, including Google and others. It was called the Celtic tiger. GDP per capita had risen to the second highest in Europe behind Luxembourg. It was following the recommended path towards financial globalization that conservative right-wing economists have been pushing for several decades.  The right-wing Heritage foundation praised it’s financial deregulation, low tax, and nearly non-existent taxes on foreign corporations as the key to success.  And by conventional measures like GDP it appeared to work.

But in 2007, things began to turn down.   Seems Ireland had developed a highly skewed and unequal distribution of income (like the U.S. today). It had become overly dependent on a property and housing boom with 12% of GDP resulting from new construction (kinda like the U.S.).  And much of the apparent GDP increases were illusion – the result of the difference between GDP and GNP – meaning life really wasn’t as good as the GDP numbers suggested.  (See  GDP vs. GNP to learn the difference between GDP and GNP and how it distorts things for Ireland but not the U.S.).  Then the Global Financial Crisis came.  Ireland got hit pretty hard. The housing market tanked. Bank loans started going bad in large numbers.  Now it should be noted that these were all private-market loan decisions.  They were the result of foreign investors making private contracts to take on the risk and make loans to people in Ireland (and outside) to buy Irish property.  But when the loans began to go bad in large numbers, the large (mostly) Euro banks’ who had made the loans had their solvency threatened.  And with that, the profits of Euro investors in those Euro banks were threatened.  The Irish government was urged to be “responsible” by taking the responsibility away from the banks and investors who made the loans.  The Irish government guaranteed the banks’ loans after the fact.  As Paul Krugman recounts:

The Irish story began with a genuine economic miracle. But eventually this gave way to a speculative frenzy driven by runaway banks and real estate developers, all in a cozy relationship with leading politicians. The frenzy was financed with huge borrowing on the part of Irish banks, largely from banks in other European nations.

Then the bubble burst, and those banks faced huge losses. You might have expected those who lent money to the banks to share in the losses. After all, they were consenting adults, and if they failed to understand the risks they were taking that was nobody’s fault but their own. But, no, the Irish government stepped in to guarantee the banks’ debt, turning private losses into public obligations.

Before the bank bust, Ireland had little public debt. But with taxpayers suddenly on the hook for gigantic bank losses, even as revenues plunged, the nation’s creditworthiness was put in doubt. So Ireland tried to reassure the markets with a harsh program of spending cuts.

Step back for a minute and think about that. These debts were incurred, not to pay for public programs, but by private wheeler-dealers seeking nothing but their own profit. Yet ordinary Irish citizens are now bearing the burden of those debts.

When the Irish government took on the bad debts made by private banks in order to save large international investors from the consequences of their bad choices , it naturally led to a large increase in the Irish government debt to GDP ratio. So in return for the good (?) deed of rescuing international investors, banks, and bond buyers from the consequences of their investments, those investors, banks, and bond-buyers have punished the Irish government by driving interest rates on Irish bonds to high levels.  The speculators smell another Greece.  Talk of bailouts began earlier this month. And, finally with interest rates rising and the speculators circling like sharks, the Irish government accepted a “bail-out” earlier this week from the Euro central bank and IMF, the usual TPTB.

I’m not sure that it should really be called a “bail-out” though.  It’s actually a strange deal like something out of  Alice in Wonderland or a George Orwell novel.  In return for the Irish government agreeing to cut spending even more, raise taxes, and punish it’s already suffering people, the Irish government gets a large credit line so it can borrow even more money in the future.  Of course, by cutting spending and raising taxes in the middle of a serious, deep recession and when it has no control over it’s monetary policy (Ireland is in the Eurozone), it will, of course have even larger deficits than is planned or expected and will need to borrow that money.  Which will only kick the can down the road to some point in the future when another “bail-out” is necessary.  God save us all from such “bail-outs”.

What  could the do instead?  Well, first off, long-term policy should be focused on growth by investing in infrastructure and education and research, much like Finland does and not in globalization and chasing multi-national banks and corporations who play shell games.  More directly, the Irish government should consider what Iceland, that other small European island in the North Atlantic did.  As Krugman also observed in the same article:

Part of the answer is that Iceland let foreign lenders to its runaway banks pay the price of their poor judgment, rather than putting its own taxpayers on the line to guarantee bad private debts. As the International Monetary Fund notes — approvingly! — “private sector bankruptcies have led to a marked decline in external debt.” Meanwhile, Iceland helped avoid a financial panic in part by imposing temporary capital controls — that is, by limiting the ability of residents to pull funds out of the country.

And Iceland has also benefited from the fact that, unlike Ireland, it still has its own currency; devaluation of the krona, which has made Iceland’s exports more competitive, has been an important factor in limiting the depth of Iceland’s slump.

None of these heterodox options are available to Ireland, say the wise heads. Ireland, they say, must continue to inflict pain on its citizens — because to do anything else would fatally undermine confidence.

But Ireland is now in its third year of austerity, and confidence just keeps draining away. And you have to wonder what it will take for serious people to realize that punishing the populace for the bankers’ sins is worse than a crime; it’s a mistake.

But to follow the Iceland example requires two things.  First, Ireland would have to leave the Eurozone and return to issuing and controlling it’s own currency. And, second, it’s politicians would have to the well-being of the Irish people above the claims and self-interest of the banks and large international investors.  I say not gonna happen.

Europe Update: Strikes in Spain, UK Austerity, ECB Bond Purchases

European leaders (read banker-types) insist on austerity (read lower real wages and services for middle and lower classes) in the midst of 10% and rising unemployment.  Dangerous mix.  The one good sign is that the ECB is actually buying govt bonds, including Greek bonds, despite it’s public hard-line position.  From Calculated Risk:

Europe Update: Strikes in Spain, UK Austerity, ECB Bond Purchases

Form the NY Times: Spain Hit by Strike Over Austerity Measures

Spanish public workers went on strike on Tuesday against a cut in their wages in what could be the first of several union-led protests against the government’s latest austerity measures.

From The Times: Osborne’s four-year austerity programme

George Osborne braced the country for cuts in government spending of up to 20 per cent as he laid the ground for an austerity programme to last the whole parliament.

From Der Spiegel (a week ago): ECB Buying Up Greek Bonds (ht Chris)

Bonds worth about €3 billion are now being purchased on every trading day, with €2 billion of the bonds coming from Athens.

From Bloomberg: Greek Default Seen by Almost 75% in Poll Doubtful About Trichet

Global investors have little confidence in Europe’s efforts to contain its debt crisis or in European Central Bank President Jean-Claude Trichet, with 73 percent calling a default by Greece likely.

From the NY Times: E.U. Finance Ministers Agree on Tighter Oversight

Despite continuing tensions over economic policy, European Union finance ministers agreed Tuesday on far-reaching steps to tighten oversight of national governments’ budgets and crack down on falsification of economic data, in a concerted effort to avert a further loss of confidence in the euro.

Why do we always find Goldman, Sachs where there’s trouble?

The Baseline Scenario concludes with a warning that Goldman must be dealth with:

And the US government, at the highest levels, has to ask a fundamental question: For how long does it wish to be intimately associated with Goldman Sachs and this kind of destabilizing action?  What is the priority here – a sustainable recovery and a viable financial system, or one particular set of investment bankers?

To preserve Goldman, on incredibly generous terms, in the name of saving the financial system was and is hard to defend – but that is where we are.  To allow the current government-backed (massive) Goldman to behave recklessly and with complete disregard to the basic tenets of international financial stability is utterly indefensible.

The credibility of the Federal Reserve, already at an all-time low, has just suffered another crippling blow; the ECB is also now in the line of fire.  Goldman Sachs has a lot to answer for.

What prompts this indictment of Goldman as public nuisance?  Greece’s troubles are threatening the Eurozone.  And how did Greece’s situation get out of hand?  Thanks to Goldman.  Shades of sub-prime and AIG credit default swaps. Here’s the full story.

At 9:30pm on Sunday, September 21, 2008, Goldman Sachs was saved from imminent collapse by the announcement that the Federal Reserve would allow it to become a bank holding company – implying unfettered access to borrowing from the Fed and other forms of implicit government support, all of which subsequently proved most beneficial.  Officials allowed Goldman to make such an unprecedented conversion in the name of global financial stability.  (The blow-by-blow account is in Andrew Ross Sorkin’s Too Big To Fail; this is confirmed in all substantial detail by Hank Paulson’s memoir.)

We now learn – from Der Spiegel last week and today’s NYT – that Goldman Sachs has not only helped or encouraged some European governments to hide a large part of their debts, but it also endeavored to do so for Greece as recently as last November.  These actions are fundamentally destabilizing to the global financial system, as they undermine: the eurozone area; all attempts to bring greater transparency to government accounting; and the most basic principles that underlie well-functioning markets.  When the data are all lies, the outcomes are all bad – see the subprime mortgage crisis for further detail.

A single rogue trader can bring down a bank – remember the case of Barings.  But a single rogue bank can bring down the world’s financial system.

Goldman will dismiss this as “business as usual” and, to be sure, a few phone calls around Washington will help ensure that Goldman’s primary supervisor – now the Fed – looks the other way.

But the affair is now out of Ben Bernanke’s hands, and quite far from people who are easily swayed by the White House.  It goes immediately to the European Commission, which has jurisdiction over eurozone budget issues.  Faced with enormous pressure from those eurozone countries now on the hook for saving Greece, the Commission will surely launch a special audit of Goldman and all its European clients.

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