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By HaleStewart August 26, 2014 4:48 pm
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Draghi's Austerity Defense Rings Hollow


          Last Friday, Mario Draghi gave a speech at the Central Bank retreat in Jackson Hole, Wyoming.  The speech contained a defense of the austerity policies pursued by various EU countries as a result of the fiscal issues that came to the forefront in 2012.  However, the data does not support this conclusion.

Draghi offers this history:

From the start of 2008 to early 2011 the picture in both regions is similar: unemployment rates increase steeply, level off and then begin to gradually fall. This reflects the common sources of the shock: the synchronisation of the financial cycle across advanced economies, the contraction in global trade following the Lehman failure, coupled with a strong correction of asset prices – notably houses – in certain jurisdictions.

From 2011 onwards, however, developments in the two regions diverge. Unemployment in the US continues to fall at more or less the same rate. [1] In the euro area, on the other hand, it begins a second rise that does not peak until April 2013. This divergence reflects a second, euro area-specific shock emanating from the sovereign debt crisis, which resulted in a six quarter recession for the euro area economy. Unlike the post-Lehman shock, however, which affected all euro area economies, virtually all of the job losses observed in this second period were concentrated in countries that were adversely affected by government bond market tensions (Figure 2).


On the fiscal side, non-market services – including public administration, education and healthcare – had contributed positively to employment in virtually all countries during the first phase of the crisis, thus somewhat cushioning the shock. In the second phase, however, fiscal policy was constrained by concerns over debt sustainability and the lack of a common backstop, especially as discussions related to sovereign debt restructuring began. The necessary fiscal consolidation had to be frontloaded to restore investor confidence, creating a fiscal drag and a downturn in public sector employment which added to the ongoing contraction in employment in other sectors

Draghi first notes that Lehman’s collapse had the same negative impact on the US and the EU, sending both economies into a recession and increasing unemployment.  However, this situation exacerbated a fundamental problem in the EU.  Greece, Portugal, Spain and Ireland (the EU periphery) had several underlying problems including a real estate bubble (Spain and Portugal) and long term fiscal issues not dealt with (Greece).  These led to interest rate spikes in all of these countries.  In order to deal with this de-facto monetary contraction, the respective countries were forced by the ECB and IMF to rein in public spending, leading to a drop in public employment that made the overall situation worse.

This argument is issued by Draghi as a defense for the policy of fiscal austerity deployed in a number of EU countries.  In his defense, interest rates in the PIGS have come down since height of the fiscal problem.  However, despite a decrease in government spending,

the respective debt/GDP ratios of the periphery have increased since then, indicating that austerity policies have not had the desired impact.

Why is this – that is, why didn’t the decrease in government spending lead to a decrease in the debt/GDP ratio?  Because the decrease in government spending made a bad situation worse – namely, a very bad recession in which consumers and businesses had stopped spending.  That left the government as the only viable source of economic stimulus.  But at the very time the economy needed a shot, that shot was taken away.  The IMF noted as much in a report from 2012:

The International Monetary Fund admitted it had failed to realise the damage austerity would do to Greece as the Washington-based organisation catalogued mistakes made during the bailout of the stricken eurozone country.

In an assessment of the rescue conducted jointly with the European Central Bank (ECB) and the European commission, the IMF said it had been forced to override its normal rules for providing financial assistance in order to put money into Greece.

So, what could they have done?  There were several options, starting with letting Greece leave the union and issue their own currency.  Or, the ECB (or other national banks such as the Bundesbank) could have been far more aggressive in backstopping the government debt market of the periphery.  It certainly would have been better than the current situation, which has arguably solved nothing.

Hale Stewart is a former bond broker who has been writing about economics and financial markets since 2006 on the Bonddad Blog.  He is also a tax attorney with a domestic and international practice while also forming and managing captive insurance companies for US companies.   You can follow him on twitter at:@captivelawyer 







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