Thursday, 1 March 2012



Starting with Greece, the markets have experienced quite a bit of turbulence that was on the way out due to the heavy handed intervention of the ECB and of various EU governments, most notably Germany. But some softer than expected macro data, fears about budget cuts and about tax rises have now grabbed the headlines. As governments try and deal with their national deficits, will we experience a double-dip recession?

Western governments are heavily indebted. If you include future commitments, they are as good as broke. Any increase in interest rates would have tragic consequences as the debt servicing charge would explode upward. Rightly fearing that speculators and bond vigilantes might start to demand higher rates for holding their debt and thus trigger a crisis as in the case of Greece, governments are hurrying, especially in the UK and Europe, to cut government spending, raise taxes and/or lower social benefits.
As is obvious to all economists, such actions will lower overall demand. If the private sector turns out to be less resilient than thought, we will surely experience a double-dip recession. And, of course, tax receipts will then fall as well, thus cancelling any hope to reduce deficit levels.

Increasing taxes, apart from being unpopular, will similarly suck out people’s spending capabilities, similarly depressing overall demand. Worst, if Christina and David Romer, of the University of Berkeley, are correct, taxes are subject to a multiplier effect – That is, raising taxes by 1% decreases activity by more than 1% - According to their research, the multiplier is 3x. Thus, raising taxes by 1% will lower real GDP by 3%! When the economy is expected to grow at around 1%, the tax raises contemplated by European governments would push the economy straight back into recession if the Romers are correct (to be complete, they do estimate that the effects of tax increases induced by deficit-reduction are the least negative ones, out of what they call “exogenous” fiscal actions).
So are the fiscal hawks wrong? Should we let the budget deficit grow for the time being? Maybe but, given that governments are heavily indebted, this would definitely be sailing very close to the wind. If a recession is bad; an international run on your debt and bankruptcy are not much fun either.

Some have argued that, fearing deflation, central banks will continue or renew their “quantitative easing” policies or monetization of government debt and indeed of any debt on a scale not seen before - until inflation finally takes hold. And, as long as debt or benefits are not indexed on inflation, this would be a solution of sort. This is the old technique of using inflation to devalue debt while avoiding default.
Of course, inflation and hyperinflation generate their own problems and easily degenerate into stagflation episodes. The Germans still remember the 1920s with fear and some have credibly linked that staggering episode of hyperinflation with the rise of fascism in the 30s.

Are the western government in an unsolvable quandary as a result of the super debt cycle developed markets went through in the last 2 decades?
I do not think so. However, the required level of international cooperation and even of internal adjustment makes such a positive exit strategy unlikely. Whether we get a double-dip recession or ‘just’ see a softening of an already weak growth for the next five or ten years, the future for developed countries is rather bleak.
As described above, the problem is, above all else, a matter of aggregated demand being too low. It needs to be raised. Western governments have tried to substitute themselves to western consumers but they are reaching their limits. The Chinese government was also pretty aggressive in its support of growth but it certainly can afford it a lot more than its western counterparts.
But a few entities’ balance sheet is still strong; I mean corporations. Corporate profits still represent a historically high share of national income, especially in a time of crisis.

And, while this is true of western companies, this is even truer of companies in emerging markets. Chinese labour costs have been kept low for far too long and we have seen the imbalances this has created as western workers substituted debt growth to compensate for their anaemic salary growth.
What we need is thus simple in theory: We need countries’ competitivity to get re-aligned via salaries increase and we need consumers to see their disposable income increase.

Will we see any of part of that solution implemented? My guess is that we won’t - or nowhere near enough to make much of a difference. China promised to revalue its currency but it will proceed deliberately slowly. Chinese workers are striking – and getting significant pay rises (20% and more in some cases) but the truth is that, with 6.7 billion people, it is doubtful labour has the upper hand on capital in the dividing of productivity gains. And since it makes no sense for any individual company to raise its employees’ salary, we will just wade through years of morass and weak growth… until biotechnology or some other unforeseen tech revolution unleash a new wave of above-trend productivity gains.