Debt, Growth, Austerity and the Rest of the Confusion In the USA and Europe

 

Thursday, December 08, 2011

Debt, Growth, Austerity and the Rest of the Confusion in the USA and Europe.

                           By

             Dr. Michael Sakbani

 

      

               (the outline of a lecture given by Dr. Michael Sakbani at an International Conference on     debt on 12/11/2011 at Webster University, Geneva, Switzerland)
 
Ladies and Gentlemen
   I am going today to talk about the Confusion called the debt crisis. In fact, it is the crisis of the political class in Europe and the USA. Debt is normal for individuals and countries. what is not normal is to make it a way of living and ignore what will happen next or refuse to deal with the crisis when it explodes. Let us give the picture first:

-          US Public debt at the end of 2010 at $ 14.96 tri, US GDP was $ 15.02 trillion. Public debt to GDP was 99.6%. Excluding due payments to Social Security and Public Pensions, the privately held public debt is 68% of the GDP. Among the developed industrial countries, only 9 countries have a debt GDP ratio higher than 100 % (Rogoff/Reinhardt).

 

-           The net interest service of the debt is 9.5% of the US. budget.

 

-         Potential crowding-out; Is it real?

only if the country is closed is this a possibility. the example of the USA during the Reagan years, when the US borrowed from the rest of the world the equivalence of its budget deficit.

 

-          Burden of the stock of the debt on future generations, The Sargent- Barrow equivalence hypothesis. this is a theoretical hypothesis about people anticipating higher taxation in the future, the consequence of which cutting their current outlays. There is no empirical proof of that. After the 2008 crisis, like most of the assumptions of the new macroeconomics, it proved unsupported.

 

-           the structural problem for the budget, impact on discretionary policies (investments in tech., education, and infrastructure); only 19% of US expenditures are discretionary.

 

-          the US dollar and US borrowing ability. are unlimited as long as the rest of the world has no alternative international key currency and is willing to hold and accept dollars.

 

-          Dependence on foreign funding. As the political developments in Greece and Italy have shown, in a globalized setting, the financial markets can rob a heavily indebted country of its economic sovereignty.

 

-          The Pattern of use of global international savings. Is it normal that the most advanced country is the biggest borrower of international savings? 

 

Why did the US get into a debt Problem?

 

-          Reagan and Bush each added $ 4 trillion to the deficit. The former to finance military expansion and the latter to fight in Iraq and the war on terror.

 

-          The weakness of the BOP of the US: Manufactures disappearance, Chemicals and restrictions on them, Energy, imports, high propensity to import for  consumption, high propensity for foreign goods: eg. cars 

-          The structure of the US budget is such that there is very limited room for discretionary spending.

 

-          Inability to deal with the problems at the political level. because of partisan politics in Washington.

 

-          Deterioration of the US financial position since 2001.: the start of the subprime mortgages accumulation, the globalization of financial markets has attracted to the US volatile financial inflows and has equally generated volatile outflows.

 

1. The structure of the Budget expenditure:

 US Federal Budget in 2010 stood at $ 3.’5 trillion  of which 25 % is spent on the military and on wars,  9 % on servicing the net interest of the public debt, 52% on various mandatory entitlements, 19 % discretionary.

 

-          The total tax collection of the three levels of Government is about 18.3 % of the GDP, much lower than any other industrial developed country.

 2.  Reasons for the recent US financial deterioration since 2001:

 

-          Revenue decline (28%)

 

-          Increased defense expenditure(15%)

 

-          Bush tax cut (13%)

 

-          Increase in net interest payments (11%)

 

-          Other tax cuts (8%)

 

-          Obama’s stimulus (6%)

 

-           War on terror (2%)

 

-          Increases in medicare (2%)

 

-          Other reasons (8%).

 

The breakdown shows that the US recession is responsible for 42 % of the deficit, while the structural elements account for the 58%

   

 

The US public is in virtual revolt against paying more taxes as taxpayers do not see direct benefits to public Federal expenditures. Yet, it wants social programs and military spending.

 

US press has not opened any public discussion of the pattern of public expenditure. 

 

48% of Americans do not pay Federal income tax. Since the Reagan era, US politician have fed this aversion to paying taxes without ever pointing out the implications.

 

The US economy has not recovered fully from the recession even after 4 years. the US is running 8.6 % unemployment on official statistics but more than 12% if one factor in the statistics part-timers, and people who dropped out of the active labor force.

 

- Consumers demand, which has historically been 67% of aggregate demand, is now only 60% of AD. -Today, the corporate sector in the US has profits twice their size of 2007, but it produces 10% less in value added to the GDP.

 

Conclusions:

 

-1.The US public indebtedness is for the foreseeable future out of control unless major changes in the tax and expenditure structures are made.

 

2.      2. The US has hardly any room to use discretionary spending to steer its economy or undertake investments in infrastructure in new technologies and in any social educational domains. This threatens future growth.

 

3. The US economy is in recession for reasons that have yet to be dealt with effectively.

 

4.       4. The debate on dealing with the large deficits has had no strategic design; there is a     wide consensus on cutting the budget without factoring in the adverse impacts on economic growth. Indeed, growth is more effective in reducing the growth of debt than mere austerity.

 

5.       5.Split on what to cut and what to increase (rep. debate).

 

6.       6. There is a massive need for investments in new technology, human resources, R &D and infrastructure if the US wants to safeguard its leading economic position.

 

7.       7. Large segments of the public harbor a deep sense of social injustice, as the top 1 percent of income earners in the US have doubled their share in the GDP to 20 % in the last decade.

 

8.       8.US global firms have moved away many jobs to garner global profits and these jobs have not been replaced by more intensive skills jobs.

 

9.       9. the  US cannot afford its entitlement programs and its military spending.

 

Europe: EU and Eurozone.

 

The EU 27 members had in 2010 a collective indebtedness of $ 12.9 trillion. Their Combined GDP        stood at $16.3 trillion resulting in a debt ratio of 80%.

 

The Euro monetary zone total GDP stood in 2010 at $12,458 trillion, while their debt stood at little more than $ 9.1 trillion, thereby resulting in a debt GDP ratio of 76 %.

 

Seven members are indebted at more than this average ratio. If one eliminates France (81%) and Austria (72.3%), Greece, Italy, Belgium, Ireland and Portugal had in 2010 debt-GDP ratios between 142% and 93.0 %. For Greece and Italy, the ratio is certainly higher in 2011.

 

Except for Germany, Sweden, the Netherlands, Slovakia, Poland and Finland, other members are either in recessionary conditions or anemic growth. The eurozone combined growth over the three quarters of 2011 was only .2 %.

 

Europe’s social compact involves a great measure of social solidarity. However, without significant increases in productivity or human and other resources, Europe cannot afford such a social compact.

 

Europe has a severe demographic problem, which is non-amendable to immigration solution in as much as its societies loath multiculturalism and its various states have no immigration policies. As a result, its pension systems are in stress and need significant reforms.

 

Almost all European countries are now adopting restrictive macroeconomic policies. In view of their very large intra- trade and connections, this stance leaves no room for trade-led growth.

 

The Euro was launched as a political project without thinking carefully about its economic design. It is a monetary union whose Central Bank does not have a bank of last resort function and is barred from lending to its member states. The fiscal policies of the member states are independent and in recent years nonconvergent. Although there are common criteria, there are no mechanisms of enforcement. There is no Union authority over sovereign fiscal decisions by member states. The Union has no sovereign governmental authority to decide resource transfers when needed.

 

The Eurozone incorporated, knowingly and purely on political grounds, states whose economies are inefficient and uncompetitive (Portugal, Greece, Spain, Italy and Ireland) The internal balance of payments deficit of the weak countries shows up in significant debt positions of their respective national central banks vis a vis the ECB. In effect, the Eurozone is not an optimal currency area, in as much as labor, capital, and public transfers are, for a variety of sociological and other reasons, not completely mobile. And, if resources and labor were perfectly mobile, members' public opinions would not accept the national consequences of such mobility.  If these deficits remain, there should be income-employment and price-wage adjustments and deep structural reforms that affect wages and the standards of living. Otherwise, the EMU risks becoming a transfer union.

 

Greece and Italy:

 

Both countries have recently been in financial limelight. I will take up the problems of these countries bellow.  

 

The Greek economy is uncompetitive; export labor unit costs 44% more to import from Greece than from next-door Turkey.

 

The export sector is dominated by tourism, thus, domestic prices rule most services.

 

Greece does not have outside maritime transport, world-class big export firms.

 

The budget has been bloated for decades; it pays very high salaries and pensions. Greek banks have weak capital positions and deteriorating assets. The state must drastically cut its expenditure and increase its taxes engendering in the process of severe deterioration in the standards of living.

 

Eurozone recent package to help Greece is neither sufficient nor well designed. The agreement has four pillars. It established a European Financial Safety Facility ( Euro 440 billion with unexplained gearing potential), approved a package of lending to Greece by the IMF, the European Bank and Governments (Eur. 140 billion), forced specific austerity measure on Greece’s budget instituted performance and monitoring clauses and restructured Greek private debts, down to 50% of their book value.

 

After this hair cut, the Greek debt ratio will go down from 160% to 120% of the GDP, the same as Italy. Interest yield on 10-year Greek bonds has passed 7 %, some 511 basis point higher than the German comparable yield. At 2.1 % inflation, the real interest rate is 4.9 %.

 

To pay this interest on the stock of the debt without deterioration in living standards, Greece should grow at about 5.88 % in real terms. Greece has averaged only 1.5 over 2001-2007 and is now expected to shrink in 2012 by 6.0 %. Under the Euro- system cannot adjust its exchange rate. Therefore, Greece cannot on objective grounds continue being in the Eurozone without other buying its debts.

 

 

 

Italy,

 

the third-largest member in the Eurozone has a debt GDP ratio of 120%. Italy must grow at 5.96 % per year to keep its debt burden steady.

 

Italy has grown by 1.3 % in 2010 and is expected to shrink by 2.2 % in 2012. It has shrunk by 1.3 in 2008 and 5.2 in 2009. The Italian economy is not competitive and its exports cannot be helped, as in the past, by currency devaluations. It needs substantial income and price adjustment and deep structural reforms.

 

The good thing is that the Italian state owns significant and viable assets, which can be sold. Italy also does not run a significant budget deficit; its 4% deficit is modest by European current standards. Moreover, the majority of its public debt is domestically owned. Sr. Berlusconi’s resignation will be helpful in the financial markets once the new government is installed.

 

Italy’s main problem, besides economic mismanagement, has been the deterioration of its productivity. While Italy has some world-class export firms, its small and medium-size firms dominate. This is not helpful to increasing productivity and is a source of its large underground economy.

 

Italy, Spain, Greece, Portugal, Ireland and Austria are all in need of structural economic reforms. These include labor market liberalization, privatization of some state assets, pension reforms, tax and expenditure adjustments and a variety of other measures to improve competitiveness within and without the Euro Zone. In some respects, even France is in need of such reforms.

 

The Eurozone sovereign debt problems will feed into a global banking crisis. Within the Eurozone, banks from France, Germany, Italy and Spain have large Greek and Italian assets. This crisis will have two main dimensions, deterioration of bank balance sheet assets, and capital inadequacy. It will also result in erosion of the value of collaterals and mutual default insurance contracts, as the value of these instruments fluctuates with the cycle. Globalization of financial markets synchronizes this fluctuation globally and renders banks everywhere simultaneously vulnerable.

 

Conclusions:

 

-1.  The Euro package for Greece arrived at in October needs to be revisited: There are five ways in which the Eurozone may deal with its debt-deficits dual problems.

 

- First, allow the European Central Bank to purchase bonds of member states, thereby printing money and in effect distributing the burden of the severely indebted countries to the strong economies.

 

- Second, keep lending to Greece and potentially to Italy, Portugal and Spain on an unlimited basis, a recipe of symptom suppression under the current Eurozone arrangement. Besides, the funds required are beyond any feasible size of the projected EFSF at any workable gearing ratio. This alternative renders the Union a transfer union, which surely would be voted down by the Public.

 

Thirdly, force adjustment in the form of structural reforms and austerity measures upon the weak economies and stimulate the strong ones to act as locomotives. That creates a two-tier Eurozone at two speeds.

 

Fourthly, force adjustment and austerity only on the weak deficit countries. In view of the rather restrictive policies of the core countries, the price and income adjustments therein would take a very long time; it took France close to ten years to adjust to 1981 payments problem through automatic price and real income adjustment.

 

Fifthly, allow controlled default and possible exit from the Eurozone. This can be done cooperatively and is perhaps easier than carrying on with the Euro Zone faulty design.

 

 

 

The current crisis points to the imperative of revising the Euro Treaty. Mrs. Merkel and President Sarkozy both brought up this issue by the end of November. In the summit of late January, the Council of Europe approved a draft treaty, in which 25 members indicated that they will sign. The revision included: stronger fiscal integration and a modified common monetary mandate for the ECB. It also created enforcement mechanisms for the Euro three criteria (debt ratio, deficit ratio, BOP ratio). There is furthermore a veto power in the hands of the Commission on budgetary decisions by member states.

 

These all are long term measures.

 

For the short term: the ESF and its gearing; the ECB (2 changes); the banks’ capital.

 

 The taboo of countries dropping out of the Euro is now broken. It is better in the long run to have fewer but more cohesive and stronger Eurozone than the present limping spectacle.

 

A possible process of devolution:

 

Greece can revert to a new Drahma for all contracts signed forthwith and for all government taxes and payments under Greek law, thereby regaining its full monetary independence. Old accounts denominated in Euros would continue on bank books. The exchange rate of the new Drahma to the Euro would find its market rate at perhaps very low levels. Europe can help in mitigating the impact on Greek debtors in Euro and the deterioration of banks’ asset values. Greece would also be helped in coping with its payments balance. There would be undoubtedly significant inflation during the adjustment. But this will be easier than staying within the Euro trying to service the escalating cost of the debt.

A strong and healthy Euro is a common international good for the International Monetary System; a viable Euro is needed as an alternative to the US dollar in the IMS.