May 29, 2012
Its not a fiscal union, its a fiscal straightjacketPosted in Financial Times · 87 comments ·
Don’t piss down my back and tell me it’s raining.” This line from The Outlaw Josey Wales, the western, is self-explanatory. In contending that the Fiscal Treaty will solve our dilemma, the European Commission and European Central Bank are pissing down Ireland’s back and telling us it’s raining.
The Fiscal Treaty will not solve Europe’s crisis. The Spanish and Irish crises stem from too much cross-border private sector borrowing and lending. Ireland’s financial crisis didn’t destroy our nation’s wealth; it merely revealed how much wealth had already been destroyed by reckless lending, borrowing and speculation.
Prescribing government deficit reductions to fix these private capital imbalances is like prescribing chemotherapy for heart disease. Today’s large fiscal deficits are a result of, not the cause of, Ireland’s and Spain’s crises. Both countries’ public debt ratios were actually lower than Germany’s in 2008 — but private debts exploded. Since Ireland adopted the euro, its household debt to income ratio has risen from 93 per cent to 220 per cent
Such huge consumer debts indicate that without growth, more mortgage defaults beckon. Ireland has too much debt, exacerbated by the ECB’s insistence that our government continue to pay unsecured bondholders of our bust banks. The bond market shut down to Ireland not because we threatened to default but because we threatened not to.
Now Ireland is experiencing an old-fashioned liquidity trap made worse by vicious deleveraging, which is destroying asset prices. Imposing more austerity now will be as useful as putting an anorexic on a diet and expecting her to become voluptuous.
Given that even in an open economy like Ireland, most of us are employed in the domestic sector, your spending is actually my income and my spending is your income. My income is also the root of my savings. But as Keynes observed in the paradox of thrift, if we all save at the same time, who is spending? And if no one replaces our spending then demand will fall and fall.
Retailers react to falling demand by cutting prices to coax us to spend. But the very fall in prices convinces people that prices will fall further and the bargain will come next month or next year. So the laws of economics are turned on their heads. When prices fall, demand doesn’t go up, it goes down.
Many Irish people’s balance sheets are broken because on the one side we have assets — houses, land and apartments — which are falling in value but on the other, we have debts, which are fixed. At a time when income is falling due to rising unemployment and taxes, this means the debt burden is getting heavier every day relative to income.
As a result, people with savings are saving yet more. Those with debts are trying to pay them down. The same goes for companies. Ireland’s savings ratio has exploded to 17 per cent of income; it was minus 5 per cent in 2007.
People don’t want to borrow because they have too much debt and banks don’t want to lend because they have too much bad debt. Yet the deleveraging is destroying their capital base too. Again, the paradox is that deleveraging my balance sheet might make my position better, but when we all deleverage at the same time, we drive down asset prices further, demanding yet more deleveraging.
If everyone is saving, who is spending? The rise in government spending is the logical reaction to, not the cause of, the liquidity trap.
As demand falls, real wages don’t fall because those with jobs protect themselves and the adjustment comes via unemployment. Irish unemployment has trebled in four years. Youth unemployment is now 29 per cent. This puts more pressure on government finances.
We are now in the fourth year of austerity and it’s clear the economy is weakening. Someone clever, not sure if it was Albert Einstein or Roy Keane, once said the definition of insanity is doing the same thing over and over again and expecting different results.
This fiscal treaty offers more of the same. It is being marketed as a fiscal union, but it is a fiscal straitjacket. It punishes weak countries when they most need help. A real fiscal union should work as the US does.
Many years ago, like many of my generation, I emigrated looking for work. I ended up as a dishwasher in Boston. Boston too had a boom and bust in the late 1980s but when it collapsed the rest of America didn’t punish it, they transferred money via the federal budget to help it recover.
With this fiscal treaty, the EU envisages doing the opposite, which is cutting spending in the periphery when we most need help. In so doing, it creates lower growth, higher unemployment, more political instability and more capital flows of frightened money from the periphery to the core. This is all being done to make the eurozone more credible. In practice it doesn’t. When the risk is deflation, engineering inflation and growth makes you credible, reinforcing yet more deflation, makes the Euro look like it has a death wish.