August 23, 2010
Last Friday, European bond markets wobbled again as investors – albeit in a thin market – got the fear.
The reason apparently was, again, Greece, where reports of soaring unemployment and complete economic stagnation are fuelling worries that the Greeks will have to renegotiate their debts. Bondholders will lose no matter what.
But they should lose.
They took a gamble and it didn’t work.
End of story.
What part of capitalism do they not understand?
The same should happen here with the banks and the bank creditors, otherwise – as we have argued in this column time and again – the people of Ireland will pay a terrible price to remain ‘‘credible’’.
I put credible in inverted commas because increasingly the word, as deployed by the government and financial market players, is actually the opposite of credible: it is incredible.
Think about what is happening in Ireland. We apparently have money to bail out bust banks – even when other banks are closing down here and getting out of their own volition – but not to build hospitals or invest in education.
This perversion is being hailed as credible by the government.
But it is not credible, it is stupid. It is monumentally stupid. In fact it is not only stupid, it is economic vandalism.
This very vandalism has resulted in us getting into a bizarre and ultimately incredible cycle.
Think about it.
The more the government says that the course of action it is on is credible, the less the markets appear to believe them.
The less the markets believe, the higher the spread between Irish bonds and German bonds.
The higher the interest premium (the risk of default), the more the government feels it has to do to impress the markets.
But the more the government talks about cutting back essential services, while at the same time being cavalier with the amounts it is prepared to put into the banks, the greater the risk here.
The reason the risk rises is that the more we cut back or tax, the more the growth rate slows.
So we are in an intellectual, as well as financial, cul-de-sac.
Instead of admitting this, the government is in denial.
Worse, it is employing quack economics to justify everything.
The quack economics being deployed is a type of fetish in certain Irish economic circles.
It is called Ricardian equivalence.
Before you nod off, let me explain the theory, which is being used to rationalise what is going on in Ireland now.
In the early 1990s,when I worked in the Central Bank, many economists there became fixated by the idea that, when a government reduced spending, the economy would actually grow, because the average person was so clever that they realised their taxes would fall in future and thus reacted to a cut in government spending by increasing their own spending.
Equally, the corollary held: that if the government started spending, the average person, anticipating that his taxes would increase in the future, would stop spending.
Thus, went the theory, increased government spending would have no overall impact on the growth rate.
The positive reaction to the 1987 budget cuts was cited as evidence for the truth of this theory, and there had been something similar observed in Denmark in the mid-1980s.
It perplexed me that clever people would believe such claptrap, when it was obvious that the devaluation in 1986 that preceded the budget reductions and the massive monetary stimulus coming from interest rates almost halving between 1987 and 1991 was what drove the economy.
The monetary expansion more than offset the fiscal contraction, and the outcome had nothing to do with people calculating that taxes would fall in the future and ‘‘bringing forward’’ spending because they felt richer.
The idea seemed tome so silly as to merit little more than a passing glance.
I mean, if people reacted like this, why did we splurge when Bertie Ahern and Brian Cowen ramped up government spending in the last decade?
If Ricardian equivalence held, we should have stopped spending from 2001 to 2007 because the government was spending like a drunken sailor.
But we didn’t: in fact we did the opposite, we spent even more than the government.
The same thing happened in the US.
When George Bush blew the American budget apart, the American public didn’t react by increasing saving.
They did precisely the opposite. Similarly now, when the Irish government is cutting back, we the people are not increasing spending, as Ricardian equivalence suggests we should; we are saving like never before.
Put simply, the idea that you can cut your way to growth using some elegant academic construct is nonsense. Historically, wherever government spending was cut and the economy took off, it was always offset by a massive loosening of monetary policy.
Think about Reagan and Thatcher: their reductions in government spending were accompanied by the biggest monetary expansion the US and Britain had experienced in peacetime.
That’s what drove the spending patterns in both countries. In Ireland, the case was the same.
The fact that the successful fiscal adjustment of the late 1980s and early 1990s was bookended by two large devaluations – one in 1987 and one in 1993 – is also carefully ignored.
Maybe this is because admitting that devaluations worked then to get us out of a hole might prompt people to ask questions about the appropriateness of the current monetary policy – and to do this is heresy.
In spite of all evidence to the contrary, there seems to be a residual belief in certain economic circles in Ireland in the idea of Ricardian equivalence.
As a result, there are people in powerful positions who contend that we will respond to more and more cuts by spending, and thus the economy will grow.
Clearly, the bond market doesn’t believe this – and what is dreadfully delusional is that the people who believe this silliness are trying to appeal to the bond market to believe it too.
We need to realise that the only thing that counts is growth.
To achieve growth, we have to do something radical. Clearly, this would be risky, but it has worked before all over the world. Is it better to do something risky or to pursue a policy that is based on Moonie economics, which has never worked anywhere?