Guest Post: Social Issues Surface as Europe Considers Fiscal Austerity to Solve Debt Crisis

Note from Ben:  I typically receive about one guest post submission via email each week.  For a variety of reasons, the majority end up not being posted.  None of those reasons include me disagreeing with the author’s perspective.  This guest post was submitted to me earlier in the week.  I strongly debated whether or not to post it.  This is a case where I fundamentally disagree with the author’s perspective, but it captures a debate that I believe will soon encompass much of the Western world and therefore I believe that it is worth posting.  However, accepting a guest post submission in no way binds me from analyzing the content of the post and suggesting an alternate way of seeing the data.  That’s exactly what I intend to do here.  I’ll discuss my thoughts at the end of this post.


 

 

 

Author Bio

Marc Brown is an Associate Editor with Oak View Law Group. He has been writing on financial topics over the years with special focus on European economy. Marc also takes interest in debt related issues and contributes articles on debt relief to personal finance blogs.

Social Issues Surface as Europe Considers Fiscal Austerity to Solve Debt Crisis

 

Some economists opine that a strict fiscal policy is the best strategy to pull the battered U.S economy back to its feet. They argue that the fiscal austerity of Latvia can be a perfect model to follow for economic resurrection. They also point out that the ruling party won election in Latvia yet again even after imposing harsh taxes and emphasizing on the need to have a tightened economy. Credit is given to the Latvian people for being responsible voters and taking the right decision. Advocates of this theory claim that Latvia is on its way to recover from a deep economic crisis.

However, things are not what they look apparently. Actually, the Latvian people cast their vote largely on the basis of ethnic issues. The ethnic Latvians (the majority) usually lend their support to ethnic parties which are inclined on taking strict measures. Contrary to what the press says, the Latvians are not happy with the austere policies of the government. Unless the political parties in the U.S can divide the audience on ethnic matters (which is quite unlikely), any attempt to attract votes on the basis of austerity in economy will result in utter disappointment.

The current situation in Latvia is not really enviable. There are serious unemployment issues and on top of that the government has cut down its expenditure on education as well as health care. As a result, a lot of people are emigrating to other countries. Do you know that about 12% of the Latvian population is working abroad currently?

It is predicted that the economic growth of Latvia will be 3.3% this year. However, with a 25% decline in GDP, this will not be enough to restore Latvian economy to the pre-financial depression state. Even the IMF has expressed concerns over the policies of Latvia’s Central Bank because the strict monetary policies are causing significant troubles to the common people. Despite its social and economic debacles, the Latvian fiscal policy (which is based on foreign currency loans) is idealized by a part of the press and the neo-liberal politicians.

The advocates of financial austerity fail to understand that strict measures are being applied on top of a pretty bad debt crisis in euro zone. It is not possible to achieve long time economic growth by cutting the wages of debt-stricken people. Moreover, it is also not beneficial to impose lower living standard on people to cut down debt. Fiscal austerity can actually be devastating and push the euro zone towards a deeper economic crisis.

Will Europe start treading on the path shown by Latvia? A number of countries like Greece, Ireland and Spain are already following Latvia’s footsteps. Jacques Delors’ dreamt of a social Europe but this kind of fiscal philosophy was not what he envisioned. We really do not want to lower our purchasing power to pay the creditors, do we?

Ben’s thoughts:

I thank Marc for highlighting an important issue that will increasingly move to the forefront over the next few years as governments all over the world seek to reduce their swollen deficits.  For a refresher, I suggest you read the following post:

Picking our poison: The icy hand of austerity or the scorching rebuke of the bond market

There are two main statements in the article that I would take issue with.  Here’s the first:

“The advocates of financial austerity fail to understand that strict measures are being applied on top of a pretty bad debt crisis in euro zone. It is not possible to achieve long time economic growth by cutting the wages of debt-stricken people.”

As I see it, this type of analysis misses a massive point:  Austerity can be involuntarily imposed by the bond market.  No elected government would ever willingly choose to embrace such an exceptionally unpopular move without being fully backed into a corner.

I would argue that this article has put the cart before the horse.  The debt crises we’re seeing all over the world are the result of the bond markets doubting the ability of sovereign nations to repay their debts (and rightfully so).  It’s the bad debt crisis that is forcing the austerity.  And contrary to the author’s position, savings and productive investment are exactly how you build a productive economy, though the temporary pain involved in a move from consumption and borrowing to saving and producing is certainly acute.

Ultimately, those who advocate non-austere approaches must answer the following questions:

  • How would they advise a country to proceed when financing their existing debt is becoming exceptionally expensive in the bond market?  Once bond holders sense that debt levels are becoming too onerous, in a cruel twist of fate they demand an increased risk premium at renewal.  Hence the spreads on PIIGS bonds have exploded to generational highs at a time when their ability to repay such debt is the most strained to begin with.
  • With more tax revenue eaten up via interest payments, where do the funds come from to maintain former spending levels?  In some cases governments find that rising borrowing costs for them and their citizens squeeze the economy just as significantly as spending cuts…..but with more long-term repercussions.
  • In the US, what is the logical course of action when QE2 has failed in its primary task of lowering the long end of the yield curve?  QE has been successful only in its capacity to induce speculation on commodity markets and buoy risk assets.  Mortgage rates have moved progressively higher begging the question of just what a credible QE exit plan looks like.

The second quote I particularly disagree with is the following:

“Moreover, it is also not beneficial to impose lower living standard on people to cut down debt.”

This assertion also misses a key point:  The government debt has accumulated primarily in the process of providing an artificially high living standard to its citizens.  Austerity does not represent a challenge to fundamental human rights, rather it is the realignment of our expectations with our economic realities.  That governments have allowed our expectations to massively diverge from their ability to meet them should have no moral bearing on the necessary outcome.

The answer

In short, there is no easy one.  Many nations are finding themselves stuck between a rock and a hard place.  Many debt-stricken nations may be well advised to force bond holder haircuts in debt restructuring.  Of course that creates banking crises as the banks are the holders of much of that sovereign debt and are leveraged to the max.  This has been the ultimate motivation for all EU bailouts so far.  The citizens are getting screwed in the process.

While Canada’s credit standing in the eyes of the global bond market is still pristine, we would be wise to learn from the stories of other less fortunate nations who have found themselves humbled and bowed at the incredible mightiness of the bond market:  We need to get our financial house in order.  That means realigning our expectations with our economic realities.  A measure of austerity is in the cards…..and rightfully so.

Cheers,

Ben

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11 Responses to Guest Post: Social Issues Surface as Europe Considers Fiscal Austerity to Solve Debt Crisis

  1. jesse says:

    Ben on the contrary I find posts like this one interesting because it fleshes out some important issues — it is not possible to do this without giving proper air to other perspectives, and the concept of austerity is wholly debatable.

    “It is not possible to achieve long time economic growth by cutting the wages of debt-stricken people.”

    Well I don’t know the alternative. Ultimately, from what I understand about Latvia (which is very little), they were borrowing abroad and needed to produce something productive. When that fails to materialize there needs to be consequences. The IMF and Eurozone are not bottomless pits; maybe it’s time for Latvia and others to harden the f%ck up, follow the playbook, or look elsewhere to satisfy its prevailing lifestyle.

  2. John in Ottawa says:

    When I was very little near the middle of the last century, I would get spanked with a ruler when I got in trouble. My mother was an enlightened woman for her time, so she would offer me a choice. Would I like to be spanked on the hand, my rear, or the bottom of my foot?

    I clearly remember, just once, saying, “Nowhere!” That got me an extra couple of swats on my rear. The choice was made for me.

  3. mac says:

    Why Latvia? What do we know about Latvia? Nothing. 12% of workers have emigrated… for all I know that’s a normal number if you look back over the past 20 or 30 years. Are they like the Irish? The Irish used to pay over 50% in taxation two decades ago, coupled with high unemployment and a low standard of living. Then came the boom and the economy grew, taxation decreased, lifestyles Americanized.

    Living in Dublin was just like living in London only house prices were even more exorbitant. Now they’re going back again to high emigration, high(er) taxation and growing unemployment. Is it normal? Ask an Irishman/woman over 36 years old… they seem to think it is. Before they were poor, emigrated and survived. Then they got jobs at home and blew a housing bubble. Now they’re poor again. I’m not sure what state the economy can be restored or recovered to or which state is normal for Ireland or for Latvia for that matter.

  4. mac says:

    John,

    I want to take a stab at answering a question you asked of Mango recently. I think she was saying, with respect to Vancouver, that local people earn local money but have to buy assets priced at international levels, ie: the housing which is priced somewhere between San Francisco & New York & Shanghai.

    But what I want to know most of all is if Mango is going to buy units at the Olympic Village now that it’s at a schmish-count? … that would be a discount on crappy, no-view units and no discount on high-end units. Can’t wait to see what happens with that boondoggle.

    • Mango says:

      This deal was done at very very high prices, the city will have to eat it or future owners. Chinese or Korean have no interest in this stuff for now.

      Van investment is best kept towards – WV, Kits, Point Grey, some areas in Burnaby, North Van.

      Metrotown area is the best value I believe.

  5. John in Ottawa says:

    From Reuters this morning we have:

    WestLB uncertainty knocks euro to 3-wk low

    LONDON, Feb 14 (Reuters) – The euro slipped to a three-week low against the dollar on Monday, hit by reports that rescue plans for ailing lender WestLB were under threat, and with euro zone peripheral debt concerns keeping investors on edge.

    Aid for WestLB hangs in the balance, a source told Reuters on Monday, as the bank struggles to come up with a rescue deal ahead of presenting a restructuring plan to the European Commission. [ID:nBAT005995]

    “The WestLB news doesn’t provide a great deal of optimism to the euro at the start of the week,” said Jeremy Stretch, currency strategist at CIBC.

    “Structural negatives in the euro zone haven’t gone away, and some of those risks are due to the banking sector. WestLB’s problems are a reflection of that.”

    Last week’s senior bondholder haircut at Danish bank Amagerbanken A/S will pale in comparison to what could happen if WestLB fails to get new financing. German WestLB is much larger.

    WestLB has been in the news since the beginning of the financial crisis when it became one of the first European banks to require a bailout. This will be a real test of Europe’s newfound resolve to limit tax payer exposure to bank bailouts.

    A little background for those of you who are unfamiliar with bank finances.

    Small banks, such as those that are going under every Friday in the US, rely on deposits in the form of savings accounts and GICs or CDs to make loans. Many such banks are called Thrifts or Savings and Loans which reinforces the community “savings” nature of the institution. Most such institutions have fewer than five branches.

    The large national banks such as Bank of America or Citigroup, have relatively small savings account balances. At any one time, most of the cash on deposit is in checking accounts. Checking accounts cannot be used against the loan portfolio (except overnight).

    So, the large banks rely on being able to borrow money to lend out and they go to the bond market to do so. These bonds have to be constantly “rolled over.” That is, as they mature, new bonds have to be sold to replace the returned principal.

    If a bank is in trouble, it loses its ability to roll over its bonds and ends up in a situation where it cannot cover its loan portfolio and it cannot pay back its maturing bonds. The bank becomes insolvent.

    I mentioned last time I wrote about banks that banks sometimes use these crisis to play games with their income statements. This allows banks that are in severe distress to look profitable and continue to issue large bonuses.

    One such trick relates directly to bond market distress. If a bank’s long maturity bonds are so poorly regarded that they are trading in the open market for say, fifty cents on the dollar, accounting rules allow banks to write off half the value of the liability and book the write off as income. This will sometimes drive an unprofitable bank back into profitability. This is justified because the bank could, theoretically if it could raise the cash to pull this off, buy the bonds back in the open market at half price.

    Thinking of investing in a bank? Make sure you really know where their profits are coming from. It is all there in the fine print.

  6. John in Ottawa says:

    As long as we are on the subject of austerity, President Obama sent a $3.7T budget to Congress today.

    There are 307,000,000 people in the United States of which 42% pay taxes. Median income is $34,140. If the US wishes to “pay as you go” then they must tax each and every tax payer $28,700, leaving roughly $5,450 to live on.

    When a budget reaches 84% of gross median income, can the debt ever be paid off?

    This is the question on everyone’s mind during this financial crisis. What does “full faith and credit” mean with numbers like these?

    • John in Ottawa says:

      I forgot to mention that of the $5,450 left after the Federal slice, the state, municipality and school board will want a slice. Oops!

  7. John in Ottawa says:

    Sorry, it is me again, but you have to see this. Those cute little bears over at Xtranormal are back at it again, this time talking about investing in Saskatchewan’s resource sector:

    Saskatchewan is kind of like your sister! Language is a bit rough for the work place, so turn the volume down low.

  8. Marc Brown says:

    Hi Ben,

    I think I wrote very frankly in my first mail that I need a back-link for this article I wrote for your readers. Please refer to this line in my e-mail “I’ll be happy with a simple attribution with my name and the site I co-author.”

    I’m not sure about the reason behind deleting the link, where after frankly hearing from me that I need a link-back to my site. So, I request you once again to insert the link in the author bio.

    If you can’t provide me a valid attribution “a link” kindly delete the article, as you’re no longer eligible to use the article in your blog.

    I hope being a decent person you’ll trouble to reply this time.

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