Sense on deficits & deleveraging: Koo & Varoufakis

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My focus is and will remain on explain­ing how the cri­sis came about, but in the mid­dle of the cri­sis, gov­ern­ment poli­cies have the poten­tial to either lessen the cri­sis or make it more extreme. Two of the best com­men­ta­tors on sen­si­ble poli­cies to lessen the cri­sis are Yanis Varo­ufakis and Richard Koo.

Yanis (togeth­er with Stu­art Hol­land) has authored the “Mod­est Pro­pos­al” to over­come the Euro­pean cri­sis (the lat­est ver­sion is here in PDF: “The Mod­est Pro­pos­al”). Richard Koo recounts the Japan­ese expe­ri­ence with the burst­ing of its Bub­ble Econ­o­my and the many pol­i­cy twists and turns after­wards in the Holy Grail of Macro­eco­nom­ics: Lessons from Japan’s Great Reces­sion.

Richard argues this case with the empir­i­cal data pro­vid­ed by the unfor­tu­nate exper­i­ment that Japan has run in macro­eco­nom­ics since its Bub­ble Econ­o­my burst back in 1990. Richard gave a keynote pre­sen­ta­tion at the Cen­tral Bank of Argenti­na con­fer­ence last week, which I have post­ed on YouTube and repro­duce below.

Both Yanis and Richard argue that gov­ern­ment aus­ter­i­ty at a time when the pri­vate sec­tor is in a debt cri­sis is coun­ter­pro­duc­tive. If the pri­vate sec­tor is reduc­ing its expen­di­ture by delever­ag­ing, then the same behav­ior by a gov­ern­ment intent on “bal­anc­ing the bud­get” will ampli­fy the depress­ing impact of reduced pri­vate expen­di­ture, thus deep­en­ing the cri­sis. Unfor­tu­nate­ly this is pre­cise­ly what the EU pro­pos­als for the PIGS are like­ly to do. Richard’s his­tor­i­cal­ly based analy­sis pre­dicts that these aus­ter­i­ty mea­sures will deep­en the cri­sis, and quite pos­si­bly result in increased rather than reduced gov­ern­ment deficits, on the expe­ri­ence of Japan.

Yanis’s alter­na­tive Mod­est Pro­pos­al is to effec­tive­ly have the Euro­pean Cen­tral Bank behave as a true Cen­tral Bank. At present the ECB acts more like a finan­cial dis­ci­pli­nar­i­an than a Cen­tral Bank, since the only debt it direct­ly funds is that of the EU itself–which is at the triv­ial lev­el of about 1% of Euro­pean GDP–while it impos­es strict stan­dards on how much pub­lic debt mem­ber states can car­ry on their own books (no more than 60% of their GDP) and how fast that debt can grow (bud­get deficits can­not exceed 3% of GDP). Mem­ber states are respon­si­ble for issu­ing and financ­ing any debt they issue them­selves.

In prac­tice, these stan­dards have been imposed very lax­ly, but in the cur­rent cri­sis they are being imposed with a vengeance on the PIGS, with Greece the coun­try most in the fir­ing line right now. Since it is almost uni­ver­sal­ly acknowl­edged that Greece can’t meet these terms, the cost of Greek debt has blown out dramatically–further guar­an­tee­ing that it will fail to meet the con­di­tions of the EU “bailout”–which of course is a means of pay­ing Greek’s cred­i­tors, rather than Greece itself.

This is very dif­fer­ent to the sit­u­a­tion in the USA. If the Euro­pean sit­u­a­tion were imposed on the US, then each State in the USA would have to issue and fund its own debt for any bud­get deficit greater than 3% of GDP: there would be Cal­i­forn­ian bonds, Flori­da bonds, etc. You can imag­ine what the rat­ings agen­cies would do to those bonds, which would in turn guar­an­tee that Cal­i­for­nia and Flori­da would go bank­rupt. Though the US States are in a par­lous posi­tion, they are not for­mal­ly bank­rupt, while the US Fed­er­al Gov­ern­ment is able to raise debt finance for itself and its States at near zero rates.

Yanis’s pro­pos­al is for the ECB to adopt the debt of its mem­ber states up to the 60% ceil­ing allowed by the Maas­tricht Treaty, and then to issue bonds to finance this debt which would then be ser­viced by the rel­e­vant mem­ber states. On the prece­dent of the US itself, this would result in high­ly rat­ed bonds that would need very low inter­est rates, result­ing in ser­vic­ing costs that could be met by the PIGS–even by Greece (Greece would need spe­cial fur­ther arrange­ments since its pub­lic debt, when the last ver­sion of the Mod­est Pro­pos­al was pub­lished, was 87% of its GDP).

The Mod­est Pro­pos­al goes well beyond this sin­gle detail, and I sug­gest read­ing the full doc­u­ment since I don’t have the time to out­line it in full here. It includes pro­vi­sions to prop­er­ly stress test the com­mer­cial banks that caused this cri­sis in the first place, to impose the pain of adjust­ment on the banks and their share­hold­ers via equi­ty trans­fers for any recap­i­tal­iza­tion need­ed to main­tain sol­ven­cy in the face of their tox­ic debts, and to finance infra­struc­ture invest­ment in Europe so that it can grow its way out of this cri­sis rather than deep­en­ing it by mis­placed aus­ter­i­ty.

Any­one who thinks that aus­ter­i­ty is the way to go, on the basis of sim­plis­tic analo­gies to the sit­u­a­tion of a house­hold hav­ing to bal­ance its bud­get or the like, should watch the pre­sen­ta­tion below by Richard Koo.

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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.