Tag Archives: Austerity

Estonia success story challenges Krugman

According to Business Week, as the US was embarking on a US$787bn stimulus package in 2009 Estonian authorities decided to march in the opposite direction and avoided running budget deficits and borrowing money to try and trigger higher growth levels. In order to maintain a balanced budget the government employed a contractionary fiscal policy and did the following:

– they froze state pensions
– lowered salaries by 10%
– raised the tax on goods and services by 2%

As a result of this:

– GDP in Estonia fell by 14% in 2009
– Unemployment in rose to 16%

Estonia – 2011

GDP grew by 7.5% and unemployment down to 10.8% which is still worrying but not as bad as Spain or Greece. However, Estonia has shown that a contractionary monetary and fiscal stance by government does lead to economic hardship but does in the long run generate growth. The IMF praised the country’s export-led recovery and its sought after fiscal position. A lot of Estonia’s success has been its desire to become part of the west since it regained independence in 1991 after the collapse of the USSR and joined the European Union in 2004. The country employed free market policies and with an open, efficient, and wired infrastructure the World Bank ranks it 24th out of 183 countries in “The Ease of Doing Business Index” – see graph.

One area that Estonia is very different than its European counterparts is their ability to follow through on prudent measures. The average salary in Estonia is 10% below the minimum salary in Greece. Furthermore pensions are also much lower and civil servants retire 15 years later. Although the graph below shows the peak of the boom in 2007 Estonian economists believe that this was fueled by cheap household credit and not realistic growth. Whilst the growth from 2010 – 2011 came from mainly exports and therefore seen as genuine. Their belief is “no pain, no gain”.

“We should repair our highways” says The Economic Naturalist

Robert Frank author of “The Economic Naturalist” and “The Darwin Economy” recently wrote a piece in The New York Times advocating tradiitonal Keynesian stimulus policy. With the US election on the horizon both Obama and Romney will be focusing on how to kick-start the economy. Obama has been a keen believer in infrastructure investment as a way to get American back into work whilst Romney has recognised the clear link between spending and employment.

In 2009 it was estimated that US roads, bridges and other infrastructure were in disrepair by the order of $2 trillion. There are many with the skills to do these jobs that are currently unemployed. Furthermore the longer you leave the repairs the more expensive it becomes. Some have said that this just puts the government into further debt but Frank argues that:

The same logic applies to overdue infrastructure investments. Yes, paying for them requires more government debt. And while austerity advocates fret that such projects will impoverish our grandchildren, they concede that the investments can’t be postponed indefinitely, and that they’ll become much more expensive the longer we wait.

It seems that there is great opportunity to stimulate growth in the economy.

The funny side of financial terminology

In the recent BBC Worldservice programme “In the Balance” management consultant turned comedian Colm O’Regan came up with an amusing take on some of the financial jargon that pervades the media.

Finance can be a bewildering world. The mashinations of big business and government as they dice with huge amounts of money involves jargon and financial terminology that make the mind boggle. Here are some of his explanations:

Bankia – a bank in Spain which requires a bailout as it indulged in too much speculation in the Spanish real estate market or what is know as banky panky.

Capitalisation – using upper-case letters in an email expressing your rage a the lack of money in the bank’s reserves

Fiscal Compact – a rather shoddily built container where Europe hopes to have its make-up. If you examine it too deeply, the foundation falls out. However if you don’t have it, you’ll be going out without your face on. And things could get ugly.

EFSF – European Finance Sometimes Fails – a whip round for people in your social circle when they are in trouble.

ESM – Even Spain Might – if bigger friends get into trouble you are going to need a bigger whip round.

Eurobonds – the friends you make among opposing fans at the European Football Championship. These realtionships eventhough they are soaked in beer and you can’t speak the other person’s language can be very intense. These bonds stand a better chance of lasting than the actual eurobonds.

LTRO – long-term refinancing operation – the distribution of large sums of money to badly behaved recipients regardless of whether they deserve it or not. A bit like being a parent.

Maastricht – a previous European Treaty requiring financial discipline with regard to government deficits. Unfortunately it was ignored and so was called the “Mass Not So Strict Treaty”. So now Europe needs another agreement called the Stability or “Much Mass Stricter Treaty”.

Turning a corner – what an Irish economy does before something even worse happens – usually the reappearance of Greece.

Euro Crisis – is it the Ultimatum Game all over again?

Jame Surowiecki in the recent edition of The New Yorker likened the euro zone crisis to the fairness trap. With Greek politicians looking at renegotiating its aid package and austerity measures, the German government has indicated that they are running out of patience and money to lend to Greece. Policymakers have talked about a Greek exit from the Euro – Grexit – which would mean they would default on their debts and no longer be part of the Euro currency.

As many economists have pointed out when economies go through a recessionary or contractionary phase their exchange rate starts to depreciate. This makes exports more competitive and imports cheaper which ultimately helps growth. However for Greece to leave the Euro it would destroy vast amounts of capital as well as costly for the rest of Europe. Greece owes almost half a trillion euros and containing the damage would mean the recapitalisation of banks, continent-wde deposit insurance and more aid to Portugal, Spain, and Italy. However it seems that this would be a much more expensive option than Greece staying in the euro zone.

Rationally there should be some sort of compromise with maybe a relaxing of austerity measures and giving Greece a bit more time to bring about some serious structural reforms especially to its tax system. However according to Surowiecki Europe isn’t arguing just about what the most sensible economic policy is but what is fair.

The Germans see it as unfair that they have to bailout Greece especially as the Greeks have continued to live beyond their means – how did they afford to host the Olympic games in 2004? Borrow more money? Why should the Germans be obliging when there is no meaningful reform in Greece?

From a Greek perspective it is equally unfair that for them to suffer years of slim government budgets and high unemployment in order to repay foreign banks and richer northern neighbours.

This fous on fairnes could prove disastrous – remember the Ultimatum Game.

The Ultimatum Game by Werner Goth 1982
In this game somebody offers John £100 under the condition that he shares it with Sarah. The two of them cannot ex- change information and John can make a single offer of how to split the sum. Sarah, who is aware of the amount at stake, can say yes or no. If her answer is yes, the deal goes ahead. If her answer is no, neither John or Sarah gets anything. In both cases, the game is over and will not be repeated. You may not be surprised to learn that two thirds of offers are between 40 and 50 percent.

From research carried out (Karl Sigmund et al.), only four in 100 people offer less than 20 percent. Proposing such a small amount is risky, because it might be rejected. More than half of all responders reject offers that are less than 20 percent.

However, why should anyone reject an offer as “too small”? The only rational option for a selfish individual is to accept any offer, as £1 is better than nothing. A selfish proposer who is sure that the responder is also selfish will therefore make the smallest possible offer and keep the rest.

This game-theory analysis, which assumes that people are selfish and rational, tells you that the proposer should offer the smallest possible share and the responder should accept it. But this is not how most people play the game.

The fairness problem is exacerbated by the fact that our definition of what counts as fair typically reflects what the economists Linda Babcock and George Loewenstein call a “self-serving bias”. This is even more pronounced when both parties feel they are not part of the same community – known as “Social Distance”. For instance:

1. The Greeks’ resentment of austerity might be attenuated by the recognition of how much money Germany has already paid and how much damage was done by rampant Greek tax dodging.

2. The Germans might acknowledge that their devotion to low inflation makes it much harder for struggling economies like Greece to start growing again.

The pervasive rhetoric that frames the conflict in terms of national stereotypes is the following:

Hardworking, frugal Germans v frivolous, corrupt Greeks
Tightfisted, imperialistic Germans v freewheeling, independent Greeks

This makes it all the more difficult to reach a reasonable compromise.

A Greek departure from eurozone = Developed world action.

Here are some interesting thoughts from the ASB bank with regard to the eurozone crisis situation. Predicted market outcomes as participants become concerned over potential contagion:

* The USD is likely to strengthen further.
* European Central Bank to cut interest rates 50 basis points to 0.50%.
* Bank of England to undertake further Quantitative Easing.
* Federal Reserve to undertake a third round of Quantitative Easing.
* Reserve Bank of Australia cuts rates 100 basis points to 2.75%.
* Reserve Bank of New Zealand cuts rates by up to 50bp to 2%,

Also look at the graphs below especially the one showing the withdrawal of money from trading banks.

Greeks start to withdraw a lot of cash

Here is a clip from CBC in Canada that discusses the issues associated with a run on Greek banks. Shows UK Prime Minister David Cameron who must be pleased that they still have the UK pound. Some interesting facts:

$894 million was withdrawn from Greek banks last Monday – 14th May.
Total Greek deposits are $215bn
Deposits down 17% in 2011

Even with the G8 meeting at Camp David how can the Greek economy get out of this mess. I suppose it really is in the hands of the Germans and what they decide. To bail them out sets a dangerous precedent for the likes of Spain, Italy and Ireland.

Euros find their way to London property market

With the change of government in France and the calamity of the Greek economy there has been a flight of Euros into the London property market. New French President Francois Hollande has proposed significant changes to the tax structure in France:

– 75% tax on income earned above €1million
– 45% tax rate for people making €150,000 more.

In recent months the real estate market in London’s most exclusive areas have become a safe haven for those holding euros as they fight to maintain the value of their money with the euro depreciating rapidly. Furthermore as Greeks start to withdraw euros from their own banks one wonders how long they can stay in the eurozone. What is for sure is that the London real estate sector is doing very well out of this. Below is a clip from CNN.

Is Spain going to go the Greek way?

With increasing debt, out of control unemployment and a general strike Spain has some serious economic problems. However, before the financial crisis of 2008 Spain was seen as a prudent member of the Eurozone with GDP debt being half that of Germany at 36%, and a well regulated financial sector. But since the aftermath of the financial crisis it has been all downhill for the Spanish economy with unemployment now at 24% and public debt at 66%.

Causes of the downturn

Like most economies before the financial crisis Spain had access to cheap credit. This was especially prevalent since entering the Eurozone interest rates, which were set by the European Central Bank ECB) in Frankfurt fell from 12.75% in 1995 to 3% in 2005.

The result
Spain’s banks and households realising that they had massive debts whose collateral was overpriced housing. Property values have fallen 27% and the building of new home is down 80% and given the size of the construction sector mentioned above this has some major implications for the Spanish fundamentals.

The Spanish economy is in serious trouble. With unemployment at 24% and the subsequent fall in consumer spending can it get much worse? Well, rating agency Standard & Poors have proceeded to downgrade Spain to BBB+ rating, which means “adequate payment capacity” and is only a few notches above a junk rating.


The above is a brief extract from an article published in this month’s econoMAX – click below to subscribe to econoMAX the online magazine of Tutor2u. Each month there are 8 articles of around 600 words on current economic issues.


Greek Dilemma

Greece’s bailout by the EU and the IMF is the largest in history – €245 billion.

The seriousness of the Greek debt problem is clear to see – see graphic below. Next month the Greek government must make it clear to those euro-zone governments and the IMF that they have made €11.5billion worth of cuts to its own spending. If it doesn’t make these cuts access to further loans will be suspended and Greece will eventually have to print its own currency. For Greece there are two major challenges as well as paying back the debt:

Debt is still rising at 1.5 times the size of the economy and
Wages and prices need to be forced downward to make the country more competitive.

In the past 3 year the Greek economy has contracted by 14% and the expectation is that it will be 6.4% by the end of this year.

IMF v Germany

In order to protect the economy the IMF suggested that there should be:

– structural reforms to the economy and
– spending cuts but over a longer period of time.

However, Germany demanded that both the structural reforms and the austerity measures should take place at the same time. This involves bringing down the budget deficit from 15.8% of GDP in 2009 to under 3% by 2014. But the spending cuts and tax increases pushed the economy into such a deep recession that the deficit got stuck at around 10% of GDP.

The exchange rate problem with the euro.

It is usual that when the IMF imposes austerity measures, it makes a country devalue its exchange rate in order to make its exports more competitive and therefore offset weak domestic demand. However, Greece doesn’t have its own currency so this is policy option is not on the table.

So where does Greece go from here? With having to impose structural reforms as well as austerity measures the country is caught between a ‘rock and a hard place’. One wonders how they are going to generate any government income with virtually no growth and increasing unemployment.

The major concern for the world economy is that if major economies are going to follow austerity programmes at the same time it will be left to the private sector to generate aggregate demand. But if they don’t borrow and increase consumer spending there is a real risk of an economic depression.

Spanish unemployment – 48.56% of under 25’s

Here is a graphic from the WSJ. There are some serious problems in the spanish economy with 48.56% unemployment of those under 25 and 22.85% being the national figure. Also from the NYT:

– 1.6 million Spanish households ended last year without a single member holding an official job.
– 33% of those unemployed aged below 30.
– 5.72 million are unemployed.
– The Bank of Spain recently forecast that the Spanish economy would shrink 1.5 percent this year, with employment recovering only in the second half of 2013.

This is worrying news for the Spanish as another recession seems likely which in turn means more pressure on jobs.