Policy Matters Archives – Page 3 of 4

Behind Optimism in the Economy, the Fed Fears the Next Recession

After a two-day meeting concluding on Wednesday, Federal Reserve officials voted to keep interest rate unchanged at a target rate of 0.25 to 0.50 percent. According to Chairwoman Janet L. Yellen’s press conference, members of the Federal Open Market Committee (FOMC) feel they are closing-in on the Fed’s statutory mandate—to foster maximum employment and price stability—and they consider that the case for a rate increase before the end of the year is still strong.

Their optimistic view of the economy is based on economic growth picking up its pace in the second half of the year, mainly supported by household spending and what Ms Yellen described as “solid increases in household income.” Meanwhile, the labor market has been tightening and some Fed officials consider the low unemployment rate to be at its full employment value, or at least “pretty close to most FOMC participants’ estimates of its longer-run equilibrium value,” to use Ms Yellen’s words. Even though inflation remains below the Fed’s target, given current economic growth and an improving labor market, we will see a pick up soon after “transitory influences holding down inflation fade.”

“We’re generally pleased with how the U.S. economy is doing,” expressed Ms. Yellen.

However, after presenting such an optimistic economic outlook, it seems at odds that Fed officials lowered their projections of GDP growth for 2016. The median growth projection for the year is now 1.8 percent, down from 2.0 percent in June. In short, it seems contradictory that policymakers believe the case for an interest rate increase has “strengthened”, while at the same time revising down their growth projections, for the third time this year.

Sending a strong signal in August that a possible interest rate hike was coming and then pulling back, made market participants question the Fed’s and Ms. Yellen’s credibility. But again, during the press conference following the meeting, Ms. Yellen said that an interest rate increase is due before the end of the year, if “we simply stay in the current course.” So which one is it? Is the economy strong enough to operate with higher rates, or not?

I think the conflicting message can be somewhat explained by noting two things. First, Chair Yellen’s remarks at Jackson Hole, last month. This speech was about the monetary policy toolkit the Fed has at its disposal to respond to future economic downturns. Among the tools, however, Ms. Yellen didn’t include the alternative of negative interest rates. Whether or not negative rates are a good idea is not the point. The point is that she declared that “doing so was impossible,” sending a strong message that the Fed is very much constrained by the zero lower bound on nominal rates. Then this past Wednesday Ms. Yellen reiterated that the zero lower bound is a “concern,” saying that monetary policy action has “less scope than [she] would like to see or expect [them] to have in the long run.”

Ms. Yellen’s remarks at Jackson Hole made it clear that the Fed trusts that, whenever the next downturn hits, “conventional interest rate reductions” will be their first line of defense. However, in order to make those reductions, rates cannot be down to where they are right now; they need some room for maneuver. For example, during the past nine recessions the FOMC cut the fed funds rate by an average 5-1/2 percentage points. Meaning that right now the Fed is 5 percentage points short of what they would need to reduce rates, if an average recession hits the economy.

Second, as Ms. Yellen noted during the Q&A, monetary policy operates with long and variable lags—in other words, that the implementation and effects of new monetary policies would normally take some time. For this reason, she argued, the principle of forward looking is so important. That is, acting ahead of time, and based on projections and forecasts, before a threat materializes. In this regard Ms. Yellen stated, “I’m not in favor of the whites of their eyes rights sort of approach. We need to operate based on forecasts.” Moreover, the Chairwoman has repeatedly stated that any adjustments in the stance of monetary policy will be “gradual,” in a succession of small increases. Thus, it would be inconsistent to keep rates unchanged when the Fed forecasts of inflation are pretty much on target for 2017 and 2018 and when monetary adjustments will be gradual and needing some time to be implemented and have effect.

It seems as if the Fed fears its ability—or lack of—to respond to the next crisis, and those fears could be weighing heavily in their considerations of a rate hike. If that is the case then the good news, for them, is that they have their favorable outlook of the economy and the principle of forward looking to justify the hike.

So, if there are no negative surprises, it’s very likely that before the end of the year the fed funds rate will increase from its current target range of 0.25-0.50 percent to the 0.50-0.75 percent range. The next Fed meeting will take place just a week before the election. Even though the Fed is not supposed to play politics, policymakers will not want to rattle the markets right before polls open. So November’s meeting is not likely to be the one, all bets are on December.

Illustration by Heske van Doornen

The Brazilian Burden

On August 29th Dilma Rousseff, the democratically elected Brazilian ex-president, defended herself at the Senate against accusations of fiscal fraud, the so called “pedaladas fiscais.” Despite her defense, two days later, the president was formally impeached, putting an end to a process that has been carried on since May, when she first left office to face trial. The crime accusations were mainly accompanied by harsh criticisms of how the Workers’ Party (Partido dos Trabalhadores, PT) fiscal irresponsibility led to the poor economic condition that the country finds itself. Among the economic meltdown and several scandals of corruption, her approval rate and the popularity of her party collapsed in recent years. After 13 years of the leftist PT administration, the presidency is now occupied by the then vice-president Michel Temer, member of the centrist Brazilian Democratic Movement Party (Partido do Movimento Democrático Brasileiro, PMDB), a party also involved in corruption scandals, and whose popularity is as bad as his predecessor.

Political matters “apart,” the Brazilian economic situation is indeed dire. GDP is expected to contract 3.18% in 2016, a second year of contraction, following the 3.85% in 2015. Unemployment increased more than four percentage points from the beginning of last year, reaching 11.3% in June 2016. Despite the poor economic performance, inflation is still above the 6.5% target roof, being expected to accumulate 7.4% this year. The inflationary pressure comes mainly as an effect of the rapid exchange rate nominal devaluation of almost 54% within the years of 2015 and 2016, reaching now R$ 3.29 per dollar. As an attempt to control inflation and attract foreign capital, the Brazilian Central Bank – going in the opposite direction of the major Central Banks – sharply rose the short-term interest rate (Selic), sustaining it at 14.25% (!!!) since mid-2015. This also had a feedback effect on the government’s total deficit. (*)

Two questions remain open: what are the real roots of the economic crisis and will the new administration be able to tackle it? To understand the roots of the bust, it might be easier to refer to the very causes of the boom that preceded it.

The boom and bust

From 2002 to 2008, the Brazilian economy performed really well, growing at an average of 4% per year. This was possible mainly by a combination of policies aimed to reduce poverty and income inequality along with the positive international scenario.

Increasing worker’s real wages and government cash transfers to poor households – channeled mainly through social security and the famous Bolsa Família – established a virtuous cycle of increasing private consumption. Another important factor was the promotion of policies towards labor-market formalization, which guaranteed not only access to social security but also the availability of poor households to private lines of credit. Note, however, that not only poor households benefited from “cash transfers”: the historically high short-term interest rate guaranteed that rich households too enjoyed the fruits of the boom. The government managed to attend then both extremes of the income distribution.

International conditions also played a major role in boosting the domestic economy. High international liquidity and the commodity-price super cycle guaranteed appreciation of the exchange rate, which beyond positively impacting domestic real wages, also helped to keep inflationary pressures under control by making foreign goods more accessible.

The Brazilian economy suffered its first hit with the 2008 financial crisis. Despite the GDP growth of 7.5% already in 2010, the fast economic recovery was mainly a result of aggressive counter-cyclical expansionary policies by the government, who acted through state-controlled enterprises (as the oil and energy companies, Petrobras and Eletrobras) and programs of investment in economic and social infrastructure. From 2011 on, GDP returned to low levels, making it necessary for the government to adopt a new set of policies that can be summarized in tax exemptions and subsidized credit expansion to private companies from public banks. As it happens, this attempt to increase private investment had the only effect of deteriorating the public fiscal situation.

The budget, the budget!!!

The change in orientation of government policies – from an expansion of public investment in 2008-10 to a provision of fiscal stimulus to private companies in 2012-14 – happened at the same time as the commodity boom ended. Already in 2011, commodity prices stagnated and, along with Brazilian terms of trade, started its downward path in 2014. The end of the commodity cycle had a harsh impact not only in economy’s aggregate demand but also on the fiscal budget.

Before we get to the fiscal issue though, please, don’t get me wrong. The cause of the Brazilian economic crisis is less a result of the end of the commodity boom in itself than by the productive structure that such cycle reinforced. Brazil’s external sector is highly dependent on the exports of primary goods, and this dependence only deepened in the past decade. In 2015, roughly 50% of Brazilian total exports were composed by primary products, a number that increased 4.5% per year since 2002, when it accounted for less than 30%. If we include natural resource-based manufactures on the calculus, it reaches nearly 70% of total exports! Furthermore, while labor productivity increased 5.3% per year from 2000 to 2013 in the agriculture sector, it decreased 0.6% per year in the manufacturing industry.

No wonder when commodity prices reverted trend the economy took a strong hit. Instead of setting the ground for the eventual bust, Brazil placed all its coins on booming commodities. Despite all the public investment programs and fiscal exonerations to the private sector, the PT administration did not manage to increase investment as share of GDP, which remained stagnant around the 18% level throughout 2002-2015 – with public investment accounting for less than 3% of GDP. Lack of investment in infrastructure and manufacturing industry perpetuated an anemic economy with low productivity and dependent on economic cycles.

Public consumption and investment decreased even further after 2014 when the rapid deterioration of the fiscal budget turned the 3%-of-GDP government fiscal surpluses to almost 3%-of-GDP deficits. It is interesting to notice that the decreasing surpluses started in 2011, not accidentally when commodity prices stagnated. We can look at the three institutional balances for the Brazilian economy, representing the government, private, and foreign sectors, as follows below in order to see these trends more clearly.

We already know from previous posts on this blog (see here and here) that the government sector has a “crowding-in” effect on the private sector, meaning that government expenditure will, by an account identity, revert in private sector savings. Of course, in an open economy, this is only true as long as we assume the foreign sector to remain “stable”. Both the private and government sectors can only simultaneously run a surplus if the foreign sector generates a surplus that is big enough to account for both. (The intention of the figure presented is not to show that the balances sum to zero – which could be demonstrated by inverting the sign of the private sector and using a bar graph – but to show the movements of the financial assets and liabilities between the three sectors).

In the case of the Brazilian economy, the improvement of the foreign sector in 2001 allowed an increase in the private sector savings and a decrease in government total deficits. Once the financial crisis struck at the end of 2007, despite the counter-cyclical policies, the deterioration of the current account was mainly absorbed by a decrease in savings of the private sector, with government persisting to run primary surpluses and to sustain its total deficit level – even decreasing it until late 2012. On that year, we observe a sharp deleveraging of the private sector which, given the steady trend of the current account, was completely mirrored by the public sector.

Once again, the mistake – to name one – of the PT administration is that instead of increasing fiscal stimulus through direct government expenditure and investment in infrastructure it bet on providing credit and fiscal exonerations to the private sector as an attempt to increase private investment. In a scenario in which – to use Minsky’s terminology – the demand price of capital decreases at a faster rate than the supply price of capital, investment will not take place. In other words, despite the stimuli reducing the cost of new investment, expectations of profits were falling at a faster rate. In a situation of lack of aggregate demand, the government has to directly spend in order to create the necessary stimulus to the private sector through the generation of profits. Its avoidance led to the deterioration of the fiscal budget through the revenue side, surpassing now 10% of GDP, a result of the economic meltdown.

Instead of stimulating the economic activity by driving aggregate demand and adjusting the economy by sustaining the levels of output and employment, the government opted, mainly after 2014, for a “building confidence” strategy in which it compromises to reducing inflation, generating primary surpluses by increasing interest rates, and cutting government deficits, an adjustment that comes, in such case, through deepening the economic recession. All of it with the intention to attract market’s attention and foreign capital inflows. It, in fact, has a huge potential to generate financial fragility – but this is subject for another post.

And what now?

To address the second question posed at the beginning of this text, it is hard to believe that the new administration will be able to revert the dire scenario. It is still unsure if Temer will have the political leverage to pass important fiscal structural reforms in Congress, such as pension reform. Temer’s pledge to sharply reduce the government deficit can be summarized in the attempt to pass a law that will impose a limit to government expenditure indexed to the inflation level of the previous year. Besides reducing the ability of the government to invest, it also means cutting spending on areas such as education and public health, thus reducing the welfare state that was established in the previous decade, a major element in the virtuous cycle.

Whether or not promising to reduce inflation and the public deficit will be miraculously enough to stimulate agents confidence in the future, it will for sure hurt the economy and lead to a further decrease in demand price of investment in the short-run. In a situation of deleveraging private sector and slow global trade, it is unlikely that private investment will rise anytime soon. Until then, workers will be the ones to suffer from the increasing unemployment levels. The interest rate, beyond undermining any conceivable investment effort that could come from private agents, also carries a feedback effect to government budget and a distributive matter, as mentioned in the beginning of this text. When the pressure to cut government spending increases, “attend both extremes of the income distribution” becomes a hard job. We already know which side was chosen. Unfortunately, very often the adjustment burden comes from the weaker side.

(*) All the data presented in the text are extracted from the Brazilian Central Bank (BCB) and the Brazilian Institute of Geography and Statistics (IBGE).

How the Government Deficit Helps the Economy

When we talk about the government deficit, it’s often in the context of bad news. Whether it’s the cover of Time magazine, appointing us each a strangely precise debt of $42,998.12, or the US Debt Clock webpage, which portrays the debt as some sort of apocalypse countdown, we are meant to fear our government’s excessive spending. Standard economics warns against high deficits out of fear that government spending will “crowd out” private investment. This assumes that, when facing a limited money supply, the government will use up all the savings in the economy, in turn reducing private investment and raising interest rates. Clearly, this is not the case, as interest rates have been extremely low in the US despite our deficit.

Let’s look at deficit spending from an accounting perspective, where we divide the economy into three main sectors: the government, the private sector, and the foreign sector. The private sector includes all private entities (households and companies), and the foreign sector represents trade. This approach was pioneered by Wynne Godley and a detailed technical explanation can be found in this paper. In a given time, the amount of money spent and received by these sectors must add up to zero. In other words, a surplus of money in one sector always corresponds to a deficit in another. There can’t be one without the other. Here’s how this manifests in the United States: In a given year, the government spends X amount of money, and receives Y amount back in taxes. If the government spent more than it received, it means the private sector, along with the foreign sector, received more than they spent. Thus, the deficit of the government reflects forms the surplus of foreign and the private sector. In order to look at the foreign sector, we use the inverse of the capital account, which illustrates the trade surplus of the US. By using its inverse we are looking at the surplus of foreign countries against the US.

Applying this approach to the US, we can use the data from the US Financial Accounts to compile the following graph:

This graph illustrates the perfect mirror image between the government’s financial balance, the private sector balance, and the inverse of the capital account (because we are looking at the surplus of the rest of the world).

The mirror image from the graph clearly illustrates how the government deficit is reflected into a private sector surplus. If the government is spending more than it is taxing, it is stimulating the economy, not taking away from it.

The History of Money: Not What You Think

Most of us have an idea of how money came to be. It goes something like this: People wanted to exchange goods for other goods, but it was difficult to coordinate. So they started exchanging goods for money, and money for goods. This tells us that money is a medium of exchange. It’s a nice and simple story. The problem is that it may not be true. We may be understanding money entirely wrong. Continue reading “The History of Money: Not What You Think”

Can we Learn from Minsky Before the Next Crisis?

Earlier this month I had a conversation with a regional manager from a major insurance company. She explained to me the many aspects of her industry: the commission based salaries, strategies to sell life insurance to one year-old children, and how to retain employees. To be honest, I don’t find insurance to be the most riveting topic out there, but I did have a question I wanted answered: What does her company do with the money their clients pay for their insurance packages? Her response surprised me for its candor, she said:

“You know, insurance companies don’t make their money from premiums and things like that anymore. Most profits come from investing in the stock market.”

We truly are in the era, as Minsky called it, of money manager capitalism. What this means is that insurance companies are no longer in the business of insurance, they are just another player in the financial markets; the only thing that differs is how they get their capital. Combine that with the fact that many of their employees have their entire pay check dependent on commissions and we have companies that are trying to sell as many policies as possible – sometimes to people who do not need it or can’t afford it – in order to have more capital for financial investments.

If that sounds familiar it is because those are the kind of practices (while obviously not the only one) that led to the Great Recession and specifically to the crash of insurance giant AIG (which was bailed out with 182 billion dollars). It is, to say the least, disheartening to see that those practices are still in place by insurers and elsewhere, but it is hardly surprising. To know why we must turn to Minsky’s Financial Instability Hypothesis.

minsky (1) — Illustration: Heske van Doornen

The Hypothesis is possibly the most notable part of Minsky’s extensive work, it is indeed brilliant in its accuracy and simplicity. Nevertheless, it seems to escape from the spotlight of economics and politics in an counter-cyclical manner: every time the economy does well, people seem to forget about it – but during the crisis his book Stabilizing an Unstable Economy went from costing less than 20 dollars, to over 800 (that is, if you could find it). Another example, The Economist had only mentioned him once while Minsky was alive, but since the 2007 crisis his ideas have appeared in over 30 of their articles. As the British newspaper puts it, “it remained until 2007, when the subprime-mortgage crisis erupted in America. Suddenly, it seemed that everyone was turning to his writings as they tried to make sense of the mayhem.” Therein lies the irony, it is exactly when the economy is booming that we should pay the most attention to the Financial Instability Hypothesis.

In short, Minsky postulated that stability is destabilizing, as Oscar Valdes-Viera has awesomely explained before in this blog. In his post, Oscar tells us to be skeptical of politicians who say the economy is doing well; that is when individuals and institutions are moving from hedge, to speculative, to Ponzi positions. In most cases, economic actors will become eerie of risk after a crisis and shun from risky investments such as CDOs. It seems, however, that this aversion to risk has not happened. One can speculate many reasons for this behavior, among which is the bailing-out of so called “Too-Big-to-Fail ” organizations.

As such, it is clear that although Minsky’s popularity increased during the last crisis, the people making important financial decision did not learn from his work. The problem of irresponsible behavior and borderline fraudulent financial innovations still remain. It is time to enact on a less popular, although still important, part of Minsky’s work: the “Big Bank”. That bank, naturally, is the Fed and it plays a number of roles: it sets interest rates, it regulates and supervises banks, and it acts as lender of last resort. However, as Randall Wray explains in a 2011 paper, “most Fed policy over the postwar period involved reducing regulation and supervision, promoting the natural transition to financial fragility.”

Case and point, the SEC and the IRS had their budget severely cut in 2014 and do not currently have the capacity effectively regulate the financial industry. To make matters worse, shadow banks and traditional banks – as demonstrated anecdotally by my conversation with the insurance agency manager – still intermingle in financial innovations. Common sense dictates that after the 2008 crisis companies should have reset to the more sustainable and safer hedge position, but it seems that many financial actors went right back to the more unsustainable speculative position after the crash. One could also have expected that financial jobs would decline in popularity post-2008, but the opposite has occurred; finance as an industry now takes 25% of corporate profits, but only makes up 4% of jobs in the US. The rising importance of the finance industry has other adverse effects besides increasing the possibility of crisis, it means that companies are not investing in producing real output for they can earn more by playing the markets.

Hence is the place in which we found the economy: misguided policy has created a weak regulatory environment where irresponsible risk-taking is ‘insured’ by the precedent set by bail outs, and where even the highest ever levels of liquidity do not lead to real investment and a strong economy. This bad omens have inspired many economists to declare that a crisis is coming. Add to that the fact that recently Minsky has been featured in mainstream media sources like The Economist, and that his seminal book in financial instability was recently the number one best seller on Amazon for Public Finance, and one has reason to feel a bit uneasy about the coming year.

Should Everyone Go To College?

On the first day of the Democratic National Committee we heard Bernie talk about how the new Democratic platform will allow children in any family making less than $125,000 a year to go to a public college or university tuition free, while substantially reducing student debt. This is a big win for the platform, and evidence that Bernie forced Hillary left.

Meanwhile, Obama’s Council of Economic Advisors released a report arguing that the $1.3 trillion in student debt is helping, not hurting, the US economy. They argue it is helping relative to a baseline where people would not attend college if not given access to loans to get there. They come to this conclusion using lifetime earnings models to show that on average someone with a bachelor’s degree makes $1 million more than someone without it. This then outweighs the costs of their student debt. If student debt levels rose to $500,000 for a college education, however, their argument still holds.

The thing is, the economy would be doing even better without the massive debt burden placed on our young people. As Nick Cassella of Civic Skunk Works argues, framing education like they do reveals their preference to view a college education as an investment rather than a right. It also frames a four year bachelor’s degree as “the” college education, rather than helping students to understand all the options available. As sociologist James Rosenbaum highlights, high schools and community colleges encourage almost exclusively four year bachelor degree programs to their students. This downplays important certifications and associate’s degrees. If a bachelor’s degree is a right, a public investment we believe all citizens should have, then it should be available for free without debt. If it is merely an individual investment, than it should not be promoted as the solution for everyone. The highest volume of in demand jobs today do not require a four year bachelor’s degree.

13708380_10209674501161410_3611875036576826971_o — Illustration: Heske van Doornen

The interplay of education and job access highlights the two, sometimes not overlapping, goals of higher education housed into one institution: educating our population, and training our workforce. This has been an institutional feature of the American system for some time, noted by socio-economist Thorstein Veblen in his 1918 piece The Higher Learning in America. William Deresiewicz, in his book Excellent Sheep, recounts his time at Yale and the stories he saw of youth conflicted between these two goals. Students are taught to be active engaged citizens, which for some would involve teaching and public service, yet careers on Wall Street and in big private sector firms are the ones that allow them to payoff their debts faster and make college “worth it”. Framing college as an investment discounts the true value of an education. Pushing students to take on debt to get their degrees also forces this view of college as a monetary investment rather than an investment in education. Even when it is framed as an investment, it does not payoff the same for everyone. While averaging across all bachelor’s degrees you get a million dollar payoff, those lifetime earnings are not distributed equally among all graduates. Using the 2014 ACS, I calculate that the average income of a white person with a bachelor’s degree is $63,000 versus $48,000 for a black person. The St. Louis Fed shows that racial wealth gaps still exist despite college degrees. Even the CEA report says “ten percent of workers age 35 to 44 with a bachelor’s degree had earnings under $20,000, compared to 25 percent of workers with only a high school diploma.” As an investment then, it pays off the most for those who can already afford it.

If the goal of the university system is to educate our population, then it should be a right for everyone. John Adams said that “the whole people must take upon themselves the education of the whole people, and must be willing to bear the expense of it.” If our definition of educated continues to mean a four year bachelor’s degree, we must bear that public expense and not put it on students through debt. However, if we can accept educated to be at a high school level, then we can stop the college for all rhetoric and help students better understand the demand side of the economy. For every 2 jobs that require a bachelor’s degree, there are 7 that require a certification. FRED shows 5.5 million job openings today in America. Close to a million are in healthcare and social assistance, half a million are in manufacturing and construction, and around 760,000 are in the leisure and hospitality industry. Most jobs in these industries only require associate’s degrees, certifications, or high-school educations with on the job training. These are good jobs. We need social workers, nurses, plumbers and electricians, and these jobs do not require four year bachelor’s degrees. As Rosenbaum argues “the real goal should not be the unrealistic vision of everyone becoming a doctor, but rather the elimination of the all too common outcome of youths facing dead-end jobs and unemployment as their only options.” Yet 5.5 million job openings does not come close to the over 17 million unemployed according to official unemployment numbers. When there just aren’t enough jobs to go around, we should not be encouraging our citizens to take on high levels of student debt.

Rather than suggesting workers take on debt to be “trained” for the workforce, we should focus on creating jobs that pay workers to learn valuable skills. As Minsky said, “it has never been shown that a thorough program of job creation, taking people as they are, will not, by itself, eliminate a large part of the poverty that exists.” A bachelor’s degree is not a blanket guarantee to a better life, so if we believe in having a more educated population it should be a right as the Democrats are now arguing for. If it is purely meant to be thought of as a monetary investment in training yourself for the workforce, then by looking at the demand side we see that it is clearly not for everyone. John Adams said that “laws for the liberal education of youth, especially of the lower class of people, are so extremely wise and useful, that, to a humane and generous mind, no expense for this purpose would be thought extravagant.” This education need not be a four year bachelor’s degree, but I think it should be. As it is today, we need to make sure young people are aware of all the options available in the economy, and only straddle themselves with debt if they truly will benefit from it. Getting rid of student debt for public bachelor’s degrees allows us all to benefit from having a more educated population. Without large amounts of debt to worry about, student’s can focus on learning for four more years. We have the rest of our lives to work.

Written by Bradley Voracek
Illustration by Heske van Doornen

A Sinking Ship

Eight years ago, the world economy was shaken by the worst financial crisis since the depression of 1929. Despite the trillions of dollars spent on bailouts and on governments’ attempts to stimulate the economy through monetary policies, the world has not yet fully recovered, and several developing countries are facing their bitterest share just now. Still, many refrain from acknowledging the necessity of governments to engage in a different – and more effective – policy to boost economic activity and employment: fiscal expansions. Nevertheless, the burden is getting so heavy that even the more skeptical are turning to reason.

A recent text written by three important economists at the IMF, titled Neoliberalism: Oversold? has drawn a lot of attention in the past days. Perhaps the most impressive matter that should be highlighted about the text is in its very title: the use of the word neoliberalism, so far mostly used by critics of this agenda that gained strength in the 1980s and generally associated with a sort of “conspiracy theory”. Besides that, the findings of the text should come as no big surprise to non-mainstream economists: instead of economic growth, neoliberalism has brought financial instability and increasing inequality.

This is due to two main pillars of the neoliberal agenda: capital flows liberalization and government fiscal consolidation. Freedom of the capital accounts was expected to bring about a more efficient allocation of resources at an international level. Both developed and developing countries would reap benefits from it: the former by obtaining higher returns on capital investment and the latter by receiving the necessary savings to finance capital development.

The same is true for austerity policies, which would lead to a more efficient allocation of resources domestically. Two main ideas associated with fiscal consolidation are the famous “crowding-out effect,” in which government expenditure would decrease the availability of resources to the private sector thus not resulting in any real change in the economy (a mechanism adjusted by the interest rate), and the “burden of debt”, in which public indebtedness would necessarily lead to higher taxes in the future, then transferring the “burden” to pay off the debt to the future generations.

By looking into data, the IMF authors reach the conclusion that the beneficial effects of such policies “appear to have been somewhat overplayed”. Indeed, instead of stimulating economic growth, those policies have resulted in decreasing output. Capital account liberalization has been much associated with financial instability (especially in the recipient countries), and fiscal cuts with increasing unemployment. Most importantly, such policies seem to lead to increasing economic inequality, which hurts the sustainability of economic growth in the long-run.

Fiscal consolidation and free capital flows have led to the trap that the world economy is now found: a sinking ship commonly referred to as “secular stagnation”. After almost a decade has passed since the financial crisis and advanced economies still have not engaged in fiscal stimulus despite the failure of the non-orthodox monetary policies on bringing about robust growth. Instead of having that money spent into the economy, banks and other private investors were just sitting on it – apparently, not even negative interest rates managed to encourage lenders, showing the limits of monetary policy to generate growth and sustain employment.

Furthermore, in a world in which capital flows are free, high international liquidity was mostly drained by developing economies due to the high-interest rate differentials. The increase in capital flows has a direct impact both on foreign reserve accumulation and exchange rates, which can have disruptive effects for developing countries hurting foreign trade competitiveness and risking a balance of payment crisis. In a case of increasing country’s indebtedness denominated in foreign currency, a change in the perception of international lenders might lead to either capital flood or capital flight.

This deserves special attention in the current state of the world economy. The US has not yet reached the levels of inflation that it aims (despite the plan to continue the interest rate hikes), China is going through a downturn and a restructuring of its economy towards a consumer-based one, Europe is in the brink of dismantling, and Latin America is struggling both politically and economically (with Brazil as one of the protagonists). The drop in global trade and the reverse in money flows can bring about an obstacle to the ability of developing countries to obtain foreign exchange, and thus to meet their foreign debt commitments.

With decreasing global demand and a lack of willingness to make use of fiscal stimuli, the burden of the adjustment during this sluggish riptide is the employment level. In a report from January, the International Labour Organization (ILO) estimated that world unemployment is likely to reach 200.5 million in 2017, an increase of 3.4 million new jobless people within this and the next year, with the developing and emerging economies in Latin America, Asia and Africa taking the worst impact, plummeting along with commodity prices.

How can we stop the ship from sinking? A coherent global effort to generate demand and employment is needed. Governments, especially in countries with greater economic and political leverage (such as US and Germany), should engage in fiscal expansions targeting investment and employment. With investors’ animal spirits leashed, policymakers should not count on the private sector as a source of aggregate demand, and neither on exporting their way out of the crisis – as in a “beggar-thy-neighbor” type of policy. Instead, direct employment creation should be an objective of a global coordination, which then would provide the necessary aggregate demand to revive global trade, besides being a great mechanism to tackle the neoliberal trend of rising inequality.

Ideally, this should be the first step towards a more substantial change in the international financial architecture: from one that incites financial instability through chronic current account deficits/surpluses and abrupt movements of capital, towards one that nurtures and sustains stability and employment in the long-run. [For an enlightening discussion on the subject, see here].

What we shall remember is that although developing countries are being the first ones to fall into the cold waters of depression, the whole ship will sink eventually unless the proper policies are adopted – and austerity and liberalization have proven not to be useful lifebuoys.

Written by Vitor Mello
Illustration by Heske van Doornen

Why is Austerity Still Being Prescribed?

After years of strict austerity and a worsening crisis, the Greek economy is still in a slump.

However, Eurozone officials continue to prescribe the medicine of austerity. The diagnosis for the Greek crisis was the fiscal profligacy of its government, and thus to restore the health of its economy, Greece simply had to slash its spending. As with any prescription, some short-term side effects were expected. However, year after year the side effects have gotten worse, with unemployment and poverty at all-time highs and demand at all-time lows. Meanwhile, the economy, in a deepening recession, is far from being cured. To make matters worse, despite the reduced fiscal deficits, the shrinking economy means the debt-to-GDP ratio is nevertheless growing.

In the aftermath of the Global Financial Crisis, Europe embraced austerity as the best medicine to cure its damaged economies. Conservative economists and leading institutions such as the European Central Bank (ECB) and International Monetary Fund (IMF) promoted the concept of austerity. The EU imposed spending cuts on all its members. It is using the dire situation of Greece as a warning against the accumulation of more debt. A council of Eurozone ministers, spearheaded by Germany, aggressively pushed for more austerity. Meanwhile, despite complying with the prescribed “medicine,” the health of the Greek economy grew increasingly worse…

However, the theoretical justification behind austerity is questionable. The fear of government deficits was backed by studies such as “Growth in a time of debt” by Carmen Reinhart and Kenneth Rogoff. This paper, published in 2010 predicted catastrophic economic consequences for any country surpassing a debt-to-GDP ratio of more than 90%. Backed by this research, high-ranking European officials made their case to abruptly cut government spending.

While Reinhart and Rogoff’s study created a buzz amongst conservative politicians when it was published. However, it was mostly ignored by the same politicians when it was discredited. In 2013, it was shown that the spreadsheet used for the calculations in the study was laden with mistakes. Its results were gravely exaggerated. After the errors were fixed, some correlation between government debt and slow growth remained but not one sufficient to establish causation. It is plausible to assume that slow growth is the cause of the increase in government debt. A summary of this controversy can be found.

In the early 2000s, the Greek government began to accumulate massive amounts of debt. By 2009, the government debt had reached almost 135% of GDP. The government quickly enacted extreme spending cuts. So, it is resulting in a ratio decrease that lasted until 2011. However, the Greek economy, in the midst of a deep recession. It did not respond very well to these cuts which came coupled with the added bonus of tax hikes. Domestic demand collapsed and unemployment soared. Moreover, overall confidence in the economy faded. Greek GDP fell, and the debt-to-GDP ratio exploded. Currently, that ratio is at about 180% of GDP and is projected to reach 200% by 2020. (OECD) The Greek economy is on a downward spiral in which imposed spending cuts reduce incomes, reduce spending, and further contract the economy, and limit its ability to repay its debts.

Despite the academic case for austerity weakening, the Greek parliament is forced to impose even deeper spending cuts to receive more funds from European institutions. Without additional loans, Greece would be unable to make the payments on its previous debt. However, most of the bailout money received by Greece has gone on payments for maturing loans.

The Greek sovereign debt has turned into a ponzi scheme. New loans are obtained to make interest payments on older ones, while the principals rise and the economy shrinks. The IMF, initially a main proponent of austerity, has recently come out in favor of restructuring Greece’s debt and allowing for some economic stimulus. It appears that EU officials are finally willing to listen, at least in respect, to debt restructuring. Last week, the council of Eurozone ministers agreed to discuss some debt relief. However, this comes with the same condition attached: more and even harsher austerity.

For a sick economy such as Greece, it is difficult to see how even aggressive spending cuts could nurse it back to health. After austerity has failed year after year in reducing Greek debt and revitalizing its economy, it is time to try a different medicine. Under EU agreements, countries are required to be fiscally conservative. Moreover, EU officials, under German direction, have refused to change their stance on weakening the austerity imposed on Greece. Greece’s suffering has become an example of what happens when those rules are broken.

However, if the EU wants Greece to repay its debt and recover, it needs to stop punishing it and give it room for growth. The European officials who continue to force austerity on Greece should take a step back and realize that the best way to reduce the Greek debt-to-GDP ratio and make it sustainable, is to allow for its economy to grow. Clearly, austerity measures have not brought about the desired growth and health. Greece needs a different prescription. One that would indeed stimulate its economy and not keep it locked in an ICU.

Written by Lara Merling
Illustrations by Heske van Doornen