Facts we should remember

Facts we should remember

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Joint post with Euronomist. 

There are some things which are obvious to many people. There are others which need constant reminder, even though they are perhaps more significant than the more obvious. In both cases though, remembering is important: it allows us to understand how things work, and when they do not work it allows us to understand how to fix them. Yet, the caveat here is that nothing works all the time; there is no panacea and we have to re-examine whether our understanding fits what we are trying to resolve. Here are some of the facts we should remember.

1. The Zero Lower Bound (ZLB) does not mean rates are necessarily zero

As Frances noted, the point of the ZLB is not that the interest rate is very close to zero. It’s the fact that actual interest rates for some reason cannot fall further even though the equilibrium rate of interest is lower. This renders monetary policy ineffective.  In the ZLB theory, the assumption is that the existence of physical cash means that interest rates cannot fall much below zero, since people will start to hoard physical cash to avoid the negative rates. But in the Eurozone, the same effect occurs even though real rates are much higher. The ECB has cut policy rates to near-zero, but real rates do not fall in response. So it does not matter whether the floor is at 3,4 or 8% (although for simplicity and relevance to the current situation, most proponents like Krugman use zero); what matters is the inability of real rates to fall through that floor, and this is what makes monetary policy ineffective, not the number. This is precisely what has been observed in the Eurozone for the past years.

2. People consume out of income not wealth

This is rather obvious isn't it? You'd be surprised by how many people (including us, at times!) forget about this. This is the reason why the Cyprus haircut has been more successful (measured by sheer GDP contraction) than Greek austerity measures. As you may well remember Greece has been suffering from a protracted depression, one which has lasted for the past 6 years. During this time, many measures aimed at reducing public spending and increasing revenue have been implemented. Yet, their success has been more than limited; Greece still misses her targets by a long way.

The problem rests in what they are (unwillingly we think/hope) doing when implementing the measures, which is reducing real incomes. Remember that people consume out of income; less income means less consumption both now and in the future, as people dis-save to meet current consumption needs from reduced income. Reducing real incomes therefore creates a vicious cycle of lower consumption, lower demand for goods and services and LOWER (not higher) tax revenues even if tax rates are increasing. This deflationary spiral increases both the amount and the cost of government debt. It is ultimately self-defeating, unless it is halted at some point as Irving Fisher noted 80 years ago.

3. Supply depends on demand in a financial crisis

What does a financial crisis mean? In a word: de-leveraging. Banks have been reducing their loan portfolios throughout the crisis, as Morgan Stanley shows:

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As the headline points out, bank Balance Sheets shrank by 1 trillion euros in 2013. What this means is simple: less credit in the economy, which means that demand is lowered. As old-fashioned supply and demand models show, when demand shifts downwards, supply does one of two things: either remains constant or shifts as well. In either of these cases, the equilibrium price and quantity are lower than before, at least in the short run. If the demand shift is permanent, it will (in most cases) mean a reduction of supply in the long run as well. But in the short-run, supply is still what it used to be; productive capabilities have not been hurt at all. Thus, to prevent supply-side contraction we need additional demand in the short-run.. Slashing demand after a financial crisis is thus completely counter-productive, since rather than supporting production it actually forces the supply-side to contract, doing long-term or even permanent damage to the economy. This is compatible with fact 2 above. 

Of course, proponents of Say’s Law will argue that supply-side liberalisation will stimulate demand – hence the call for structural reforms in Eurozone periphery countries experiencing demand contraction. And there is some truth in this: liberalising the supply-side while squashing domestic demand encourages business to seek demand abroad, which improves exports. But a damaged financial sector is a serious drag on both demand and supply: it does not lend either to businesses for investment or to households for consumption. Remember that there is no cure for everything; different problems require different solutions. And at heart, the Eurozone crisis is in reality a financial crisis.

In essence, a financial crisis is a demand, not a supply shock. But demand shocks feed through into the supply side anyway, so the small depositor haircut in Cyprus would have hurt businesses at least as much and possibly more than the large depositor haircut actually implemented. Yes, it might have forced them to look for export markets, as austerity in other Eurozone periphery countries is doing. The problem with exports is that their benefits are in the medium-term and not the short-run, as most businesses cannot shift very fast (or at all, depending on their size and target market). And exports are not a substitute for domestic demand anyway. Which brings us to our fourth often-forgotten fact.

 4. Reliance on exports does not equal a vibrant economy

Sorry Angela, but this is true. The fact is that the more export-based you are, the more prone to crises you are, as trouble in other countries is transmitted into yours. This does not mean that Germany is to blame for exploiting the situation in the Eurozone. Nor does it mean that no exports is a good policy. A country needs exports; but it also needs consumption, and consumption in Germany is anything but vibrant. German export-led growth has been achieved partly through holding down wages and squashing domestic demand, a model that is now being exported to the rest of the Eurozone in the belief that it is successful. Yet Germany’s economic performance since the start of the Euro has been considerably less than stellar, largely due to its low domestic demand.

 The large current account surpluses mean that they have to stream that flow of cash somewhere, and since domestic demand is low it goes into investments abroad (here's looking at you, Deutsche). Yet, as the previous link shows, results have not been what were expected by investors, even without mentioning the sub-prime mortgage fiasco. Investment abroad increases the risks to the German banking system without, in the long run, benefiting the domestic economy. Put simply: not spending in your own country means fewer domestic jobs in the long run, since the funds sent to other countries assist in building consumption in them, thus boosting investment and supply. Eventually this will result in new products being created, (with a considerable amount of economic literature finding that the import of goods also means the import of their embedded R&D) which will probably hurt German exports.

In conclusion, we believe that the above facts summarise what we have learned (or perhaps, what we have been reminded of) during the past years; important knowledge which we hope will not be lost in the future. These facts also allow us to forecast the world we will soon experience a bit better: as demand in the periphery increases (both from German investment as well as domestic consumption) so will output. Germany’s reliance on exports may become costly in the future if she continues with the same modus operandum, and increased government spending will be the only boost if real rates are unable to fall further. 


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