Dr Andrew Lilico, June 2013

Is Austerity Enough to Save the euro?

1. Austerity alone won’t be enough to save the euro

2. Debt pooling (e.g. Draghi) is making things worse

3. Don’t expect ECB to inflate as much as Fed or BoE

4. Expect to see increased use of gold & bank bail-ins

5. Political way forward is to Single European State

2

Key Messages:

There are major austerity programmes across much of the €urozone

3

Program tax revenues

as % of GDP

public expenditure as %

of GDP

fiscal balance as % of GDP

expenditures from peak to trough as % of total

expenditure in peak year

Austerity plans

Portugal 1% -7% 7% -13%

Ireland 1% -6% 7% -6%

Italy 1% -3% 4% -1%

Greece 1% -12% 13% -24%

Spain 2% -5% 7% -6%

Belgium 1% -2% 3% No fall

France 2% -4% 6% No fall

Austria -1% -3% 2% No fall

Memo UK 2010s 1% -8% 9% -6%

In a currency union, austerity is about controlling government deficits & debt…

4

2010 figures (Eurostat) Govt debt to GDP Govt deficit Bank assets to GDP

Avg Growth 2000-2010

“Unsalvageable”

Greece 143% 11% 173% 2.4%

Cyprus 61% 5% 586% 2.8%

“Banking crisis”

Belgium 97% 4% 182% 1.4%

Spain 60% 9% 335% 2.1%

Ireland 96% 32% 328% 2.4%

“Competitiveness Crisis”

Italy 119% 5% 163% 0.2%

Portugal 93% 9% 240% 0.7%

…but austerity is also about restoring competitiveness

5 Source: Europe Economics & Open Europe

It’s simply not true that more deficit always equals more stimulus

6

Does a 99% of GDP deficit provide more stimulus than a 98%

of GDP deficit?

At some point “Non-Keynesian” effects must dominate: • Signalling effects concerning the

growth rate of the economy High spending = low growth

• other wealth effects on consumption Deficits resolved / debts paid

with taxes

• credibility effects on interest rates “Gilts strike” / “yields spike”

Often Fiscal Austerity is Accompanied by Monetary Loosening, but doesn’t have to be

7

2003

49 Consolidations Considered • Typically lower deficits than in €urozone

today • In 24 cases growth accelerated following

the start of deficit reduction, even in the short run • In 13 of these cases, there were

significant monetary expansions or devaluations

• In 11 of these cases, there were not

Giudice, G., Turrini, A., in 't Veld, J. (2003) “Can fiscal consolidations be expansionary in the EU? Ex-post evidence and ex-ante analysis”, European Commission DG ECFIN

€uro Members differ in past experience of deficit reductions with / without devaluation: • Greece / Portugal needed devaluations • Spain / Italy didn’t

8 -4

-2

0

2

4

-400

-200

0

200

400

19

81

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82

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83

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84

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85

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86

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87

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88

19

89

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90

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91

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92

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93

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94

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95

19

96

19

97

Spain (1981-97)

-4

-2

0

2

4

-400

-200

0

200

400

Portugal (1986-97) Change in fiscalbalance (% of GDP)

-400

-200

0

200

400

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

-4

-2

0

2

4

Italy (1988-97)

-4

-2

0

2

4

-400

-200

0

200

400

19

81

19

82

19

83

19

84

19

85

19

86

19

87

19

88

19

89

19

90

19

91

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92

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93

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94

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95

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96

19

97

Greece (1981-97)

Change in exchangerate vs DM relativeto underlyingchange 1981-2002

Some €urozone Austerity Programmes are undeliverable

9

Program fiscal balance

as % of GDP

expenditures from peak to trough as % of total expenditure

in peak year

Number of years spending cut till

trough

Number of years spending remains less than peak year

Austerity plans

Portugal 7% -13% 3 >6

Greece 13% -24% 5 >7

Italy 4% -1% 3 6

Historical

Ireland 1990s

10.6% -8.7% 2 3

Canada 1990s

9.5% -4.3% 2 2

UK 1980s

4.3% -3.3% 4 6

UK 1920s

3.7% -11.4% 3 6

The EU and Democracy: • 11 EU Members have been members for longer than they were

previously democracies outside the EU • 19 joined the EU within 17 years of becoming democracies • Yet EU is mechanism for by-passing democratic pressure

10

Country Year of most recent

introduction of democracy*

Year of Accession to

EEC

Years democratic outside EU/EEC

PIIGS

Greece 1974 1981 7

Ireland 1832[?]/1922 1973 141[?]/51

Italy 1948 1952 4

Portugal 1975 1986 11

Spain 1978 1986 8

Others

Austria 1945/1955 1995 40/50

Belgium 1944 1952 8

Bulgaria 1991[?] 2007 16[?]

Cyprus 1974 2004 30

Czech Republic

1989/1993 2004 15

Denmark 1945 1973 38

Estonia 1991 2004 13

Finland 1906 1995 89

Country Year of most recent

introduction of democracy*

Year of Accession

to EEC

Years democratic outside EU/EEC

Others

France 1944 1952 8

Germany 1949 1952 3

Hungary 1990 2004 14

Latvia 1990 2004 14

Lithuania 1992 2004 12

Luxembourg 1945 1952 7

Malta 1964 2004 40

Netherlands 1945 1952 7

Poland 1989 2004 15

Romania 1990 2007 17

Slovakia 1998 2004 6

Slovenia 1990 2004 14

Sweden 1907 [?] 1995 88 [?]

United Kingdom

1832 [?] 1973 141[?]

Under the OMT (“Draghi Plan”) the ECB uses its balance sheet to indirectly reduce the costs to Eurozone Member State governments of financing their debts

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The EU Treaty forbids the ECB from financing Member State governments for two very good reasons: (a) Such financing involves a form of fiscal transfer between Member States conducted covertly under the auspices of monetary policy. (b) Such financing is potentially highly inflationary. But don’t expect the ECB to inflate as much as the Fed or BoE!

Austerity should be mitigated by fiscal transfers, but it is a grave error to assume “fiscal transfers” = “debt pooling”

12

Without conditionality:

In academic studies (Gneezy, Haruvy and Yafe, Economic Journal 2004), splitting the bill => 36% higher bill

With conditionality:

Countries can do more to help themselves… e.g. by showing willingness to provide collateral (e.g. gold) for bonds

13

Use for bonds better than ex post sales since achieves leveraged effect. Italy could cover more than two years of debt issuance with gold-backed bonds. (So could Portugal, but Portugal very likely to default, so more likely to use gold post-default, a la Cyprus.) Use of Italian gold as collateral implies no fiscal transfer, no lobster problem, no vassal problem, and no inflation risk, whilst addressing the same “market failures” The gold in question is an Italian asset, not a German or Eurozone asset, so no fiscal transfer is implied by its use. (But use must be approved by ECB.) Gold is a real asset, not a nominal asset, so there is no money creation and thus no inflationary pressure created by its use. The use of such gold reduces liquidity risk and reduces depreciation incentives.

Countries can do more to help themselves… e.g. by showing willingness to allow bank creditors to take losses

14

If you lend money to a chip-shop and it goes bust, you’ll own a chip-shop. Same with a bank. European Commission’s 2012 Bank resolution directive adds “bailin power” in respect of bonds and deposits over insurance threshold when banks not yet bust (already exists when they are bust) With bailins, Irish & Spanish governments would not be bust. Cypriot bank creditors losses scheme arbitrary & disrespectful of property rights – not because depositors lost (that was a Good Thing) but because losses imposed on large depositors were not simply the losses of the bank. They also paid to insure the smaller depositors (since the Cypriot government could not afford to do that). A new risk.

…but currency unions work, politically, when ongoing, decade-after-decade, fiscal transfers are large enough

15

Structural & Cohesion Funds

€58bn / year

& others

€19bn extra = 1% extra GDP

for Italy & Portugal =>

Service Own Debts

cf cost of debt pooling Total exposure for PIIGS = ~€1.7tr

Effectively taking German and French debt exposures to current

Italian levels add ~ 100bps to funding costs =>

~€36bn per year

• Initiative principle would be different

– Structural funds match funding to govt projects

• Match funding abandoned

– Brussels initiative to spend => spending sovereignty centralised

• Accompanied by tighter fiscal policy constraints

– Fiscal Union Treaty / “Six-pack”

– Running a non-trivial deficit needs to be approved by Brussels

– => fiscal sovereignty centralised

16

Complications with Ongoing Fiscal Transfers Concept

• Last for decades

• Real money, not “guarantees”

Two ways forward from here

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Or…

• Choose who’s in € and who’s not (HINT: Not Greece or Cyprus)

• Deliver austerity where feasible • Pool sovereignty • Large ongoing decade-after-decade fiscal

transfers • Political union Will this be the path they choose? Yes.

Path to Single European State