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Wednesday, February 1, 2012

Transcript: 492 The Idiocy of European Policy

Now. Idiot of the week. Today Martin Feldstein.

We choose our idiots not exclusively for their idiocy. If absence of contact with reality were the only criteria, we would have an embarrassment of riches. To illustrate this, on an upcoming podcast, if execution follows intention, we will have a Davos edition. We reduce the field considerably by including – sometimes – those who have something to say, but ignore or miss the point otherwise. And sometimes our selections have risen to the top because they are in positions of influence. Baffled Ben Bernanke has been featured here more than once.
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Today’s idiot is Martin Feldstein, who fits into all three categories. Something to say, position of influence, idiocy.

Now Professor of Economics at Harvard, Feldstein’s reputation is mostly associated with the NBER, National Bureau of Economic Research, a private organization which is the official determiner of recessions. He came out in 1982 for a couple of years to be Chairman of President Ronald Reagan's Council of Economic Advisers. Then returned to the NBER as president for a couple of decades.

In a recent Project Syndicate piece under the title:

How to create a depression,

Feldstein wrote:
European political leaders may be about to agree to a fiscal plan which, if implemented, could push Europe into a major depression. To understand why, it is useful to compare how European countries responded to downturns in demand before and after they adopted the euro.

Consider how France, for example, would have responded in the 1990’s to a substantial decline in demand for its exports. If there had been no government response, production and employment would have fallen. To prevent this, the Banque de France would have lowered interest rates. In addition, the fall in incomes would have automatically reduced tax revenue and increased various transfer payments. The government might have supplemented these “automatic stabilizers” with new spending or by lowering tax rates, further increasing the fiscal deficit.
In addition, the fall in export demand would have automatically caused the franc’s value to decline relative to other currencies, with lower interest rates producing a further decline. This combination of monetary, fiscal, and exchange-rate changes would have stimulated production and employment, preventing a significant rise in unemployment.

But when France adopted the euro, two of these channels of response were closed off. The franc could no longer decline relative to other Eurozone currencies. The interest rate in France – and in all other Eurozone countries – is now determined by the European Central Bank, based on demand conditions within the monetary union as a whole. So the only countercyclical policy available to France is fiscal: lower tax revenue and higher spending.
… blah, blah, blah

here … remembering this was written about a month ago.

The most frightening recent development is a formal complaint by the European Central Bank that the proposed rules are not tough enough. Jorge Asmussen, a key member of the ECB’s executive board, wrote to the negotiators that countries should be allowed to exceed the 0.5%-of-GDP limit for deficits only in times of “natural catastrophes and serious emergency situations” outside the control of governments.
If this language were adopted, it would eliminate automatic cyclical fiscal adjustments, which could easily lead to a downward spiral of demand and a serious depression. If, for example, conditions in the rest of the world caused a decline in demand for French exports, output and employment in France would fall. That would reduce tax revenue and increase transfer payments, easily pushing the fiscal deficit over 0.5% of GDP.

If France must remove that cyclical deficit, it would have to raise taxes and cut spending. That would reduce demand even more, causing a further fall in revenue and a further increase in transfers – and thus a bigger fiscal deficit and calls for further fiscal tightening. It is not clear what would end this downward spiral of fiscal tightening and falling activity.

If implemented, this proposal could produce very high unemployment rates and no route to recovery – in short, a depression. In practice, the policy might be violated, just as the old Stability and Growth Pact was abandoned when France and Germany defied its rules and faced no penalties.

Copyright: Project Syndicate, 2012.

And here on Bloomberg

Chancellor Merkel and President Sarkozy would have improved things if they had said from the start, "Greece is in a different position from Italy and Spain and others.  Greece can't make it.  There's no point in trying."  Instead, they said, "Well, Greece, Italy, they're all the same." As a result they've made it harder to get reasonable terms from the financial markets.

Not so idiotic, perhaps. Perhaps in the “something to say” category. Certainly well within the accepted view. What is missing? Ah, the banks, the investors, the private sector that led the world into the mess and now must be bailed out to complete the carnage.

The entirety of Feldstein’s argument has to do with making the investors whole. What is the great problem with Greece? The cataclysm that is about to unfold? Certainly not that the Greek economy and people can be spared some suffering. Certainly not that Greece is going to default. It has been a tradition in Greece to default, and has not particularly been remarked on up until now. But now the kind of market event, the bankruptcy court proceeding, the whole nine yards, cannot be contemplated.

Certainly it is because Greece is not so different from Italy and Spain, nor from Ireland and Portugal. The austerity that is biting at Greece, that was sold on the basis of establishing confidence, structural reforms, etc., etc, that were sure to lead to inevitable recovery, new investment and well-being, and instead delivered a meltdown in the economy, This is austerity demanded of Portugal, and now with similar non-results in bond spreads. Ireland did the ECB’s bidding and bailed out the banks that were not any part of the government. Ireland was the poster child of how to do it right by the private market competitiveness playbook. Now they’re sunk. Italy, Spain, etc. Similar. High debt, be it public or private, and a negative current account, meaning the negative flow is adding to the negative stock. Competitiveness cannot happen, as Feldstein notes, by way of currency adjustment, because there is only one currency. It has to come about by way of economic contraction via austerity by governments or austerity – aka structural adjustments – by the labor markets. Crunch goes demand. Crunch goes the economy. How is that different from Greece?

But no, not so idiotic. We include this part to bring up something more idiotic. A German proposal leaked to the Financial Times that quote

“The German government wants Greece to cede sovereignty over tax and spending decisions to a eurozone “budget commissioner” to secure a second €130bn bail-out….”

This is according to a copy of the proposal obtained by the Financial Times (link online). Quoting from the German proposal:

(1) Absolute priority to debt service

Greece has to legally commit itself to giving absolute priority to future debt service. This commitment has to be legally enshrined by the Greek Parliament. State revenues are to be used first and foremost for debt service, only any remaining revenue may be used to finance primary expenditure. This will reassure public and private creditors that the Hellenic Republic will honour its comittments after PSI and will positively influence market access. De facto elimination of the possibility of a default would make the threat of a non-disbursement of a GRC II tranche much more credible. If a future tranche is not disbursed, Greece can not threaten its lenders with a default, but will instead have to accept further cuts in primary expenditures as the only possible consequence of any non-disbursement.

(2) Transfer of national budgetary sovereignty

Budget consolidation has to be put under a strict steering and control system. Given the disappointing compliance so far, Greece has to accept shifting budgetary sovereignty to the European level for a certain period of time. A budget commissioner has to be appointed by the Eurogroup with the task of ensuring budgetary control. He must have the power a) to implement a centralized reporting and surveillance system covering all major blocks of expenditure in the Greek budget, b) to veto decisions not in line with the budgetary targets set by the Troika and c) will be tasked to ensure compliance with the above mentioned rule to prioritize debt service.

The madness of austerity now formalized in the hands of the madmen of austerity. The interest of the people is clearly subservient to the interests of the banks. How foolish would it be to put your budget in the hands of another state? Or a quasi-state institution controlled by the banks.

George Soros had this to say about the situation:
Unfortunately it means a lost decade for the European Union.  Similar to what happened to Latin America in the 1980's.  And it actually could be more than a decade.  Because, similar to what happened to Japan after the collapse of their boom, in the late 1980s.  They still have not grown since then.  So you have a period of ... an extended period ... of stagnation facing Europe.  That I don't think Europe can survive politically.  That is why I am terribly concerned about it.

Because the euro ... the German insistence on austerity could destroy the European Union.  This is reality.  This is a harsh reality that we need to face.  I think if we faced it, we could alter it, because it is not written in stone.  In other words, the future is not predetermined.  We determine the future.  So it would be well within the possibilities of the authorities to change it. 

Unless the Germans actually see reason, and I think now have actually the beginning of a discussion that goes to the heart of the matter.  The Finance Minister says that structural reforms alone ought to do it.  It did it for Germany.  I think not only me, but the markets, the world at large, says that is not possibility in the current environment, where you have general deleveraging and deflationary pressures all over the world.

I think the euro will survive.  It will actually benefit from all the doubts that are now in people's minds.  It will keep the price the down.  And that may actually help the Eurozone export more and actually pass on some of the pain to the rest of the world.  So there is a commitment to the euro, and you really don't have the option right now to abandon it, because you cannot unscramble the omelet.  Things are so interconnected that if you broke up the euro, you wold have a meltdown of the financial system.

However, in the long term, it threatens to destroy the European Union.  So the political consequences are very dangerous.  And the funny thing that is going that is not actually noticed, but now you have re-nationalization of the financial system.  All the government bonds will end up in the banks of the countries which issue them, and THEN it will actually be possible to break up the euro.


  1. Maybe the Germans are just looking at how smashingly successful the "austerity" of the U.S. in 1946 was, despite all of the Keynesian end-of-the-world predictions.

  2. Not sure about this comment. At the end of the war, U.S. deficits were 250% of GDP, household balance sheets were in prime condition, pent-up demand was enormous, industrial capacity was extremely tight, demand from the rest of the world was intense. The government did shut down the military in short order, absorbing 7 million men in the space of two years. A sharp inflation occurred from excess demand and commodity speculation (farmers could make 10% a month by holding onto their product). The inflation was broken. The downturn was reversed in time for Truman to beat Dewey. The experience of the aftermath of World War I was completely avoided.

    The end-of-the-world predictions were not only from Keynesian economists, but from the old orthodoxy who demanded austerity and higher interest rates to shut down the inflation. The New Deal warhorse Leon Keyserling was a key Truman adviser and the path chosen was to keep interest rates low and instead of cutting demand, remove bottlenecks as fast as possible to increase supply.

    The era of big government had arrived. The Marshall Plan and the GI bill were enacted over the objections of the austerity camp. Low interest rates were carried into 1952, until the "Treasury Accord" gave sole control of monetary policy to the Federal Reserve. The Korean War was conducted on budget. An era of strong growth, equality of opportunity and income, and stability lasted until the mid- to late-1970s.

    The Germans are looking out for their banks. It ends badly.

  3. The longer this fiasco with Greece continues I expect things to deteriorate further. Greece will soon become ungovernable. With the elections in April the next government will find that they will have riots from day one till they are ejected from office, because their hands are tied. Ultimately the bond holders have to take the pain. Greece needs a fiscal surplus for things to improve. With an increasing amount committed to debts then with a shrinking economy and rising debts and interest it will get to the point that there is no money left. What then? Seizure of Greece by bailiffs? The problem is that the current deal only just agreed will collapse sooner or later because more and more of the economy is now done away from the tax man. That will mean that debt servicing will become impossible. Greece will fall into anarchy and a coup will be the only way out.