Wednesday, 25 September 2013

What Have We Learned From The Crisis So Far?

Just like Paul Romer once said "a crisis is a terrible thing to waste". A crisis is good for several reasons: first of all it makes you understand what you have been doing wrong and allows you to fix it; whether you are willing to accept change is nonetheless something completely different. Second, it makes you get rid of your prejudices and third it makes all those theories which we have been bombarded over the years and had no connection to reality fail spectacularly. Just everything in life, we can learn a lot more from a difficult situation than from an easy one. What follows is an extract from what I believe were the most important revelations of the crisis:

1. Prices are sticky
If we exclude a small interval in 2009 in Portugal, Spain and Ireland, inflation has not been low in the countries where most of the attention has been over the past 2-3 years. The 2009 incidents can be attributed to the sub-prime lending crisis and not the European one; when the government spending cuts, reductions in wages and salaries and increases in taxation occurred, the inflation rate did not fall as spectacularly as many had expected. In fact, in cases like Greece, deflation (which should be the natural outcome of decreased money supply in the economy) did not occur until more than 2.5 years later. The trend one might argue, has been negative in Greece. True, but this does not mean anything: if austerity was to work as it was meant to be, what we needed was deflation not disinflation.

2. Wages are Sticky - Unemployment is not
Source: A Cross of Euros
The graph above hardly needs any commenting. Employment has been steadily falling in all 4 countries while wages have been falling just in Greece and increasing in all others. Even the decrease in Greece is not as large as the decrease in employment which fell by 20% whereas wages by a mere 7%.

3. Lower GDP means higher debt ratios
I cannot even remember how many times I have said this over my blogging life (but here's an example). There is nothing more mathematically obvious than this and yet it has been largely ignored by most. If a country's debt is 100 and it's GDP is 80 the the ratio is 125%. If GDP falls to 70 then the ratio goes to 143%. How more obvious can it get? That is the reason why Greek debt has been on the increase despite the 70% PSI (which forced Cyprus to bankruptcy) and various other attempts to decrease it.

4. Even if we get deflation, it increases the real value of debt
The point of austerity was supposedly to decrease spending and simultaneously decrease prices and costs. As we have seen in points one and two, this does not really happen. Yet, what we also forget is that deflation is bad for banks as well. Let's say I borrow 100 from my bank at a time when my salary is 10 per month. Because of the austerity measures and the decrease in wages and prices I now earn 8 per month. No big deal one might comment since all goods prices have decreased; all but the loan installment though. If I had been spending 5 and paying the other 5 to the bank, with a 20% decrease in wages, I will now be spending 4 and paying once more 5 to the bank, for a total of 9, 1 unit of currency more than my salary! This is nothing new really. Irving Fisher knew this in 1933 and many others, such as Mervin King the former governor of the Bank of England, made even more research on the subject. What got economists confused was that deflation is good in a simple recession but not at all good when we have a banking crisis in addition to a recession. When a recession occurs, deflation is a natural outcome which helps the economy recover; when we have a banking crisis, the already deteriorating balance sheets are better off without the added pressure of deflation forcing more lenders to default on their loans.

5. Fiscal Multipliers are greater than one in recessions
Don't take my word for it; just look what other researchers have done. Data from the 1930's are consistent with "(..)the idea that the impact of fiscal stimulus will be greater when banking system are dysfunctional and monetary policy is constrained by the zero bound." In essence, financial crises cause spending multipliers to increase by much more than their original values (multipliers in the sample varied from 0.4 to 1.9) with this making their effect much higher on the real economy.

6. People and consequences are all in the short run
How would you feel if you had no money today and someone tried to console you by saying that you will have some money 3 years from now? Not too much of a consolation I am sure. People do not live waiting for the long-run to materialize. Despite economic modelling, they cannot postpone all of their consumption for the future even if they want to; they will simply die trying. Similarly, looking at the long-term does not assist a country which has a 28% unemployment rate and whose people are fed up with policies. The time-frame in which politics occurs in the short run, whether we like it or not and this is what we have to deal with. 

Would the European South be better off had there not been for such policies? Most likely yes. But we should not forget the benefits of the euro in such circumstances. The only reason southern countries did not face a "textbook" triple crisis (banking crisis, sovereign crisis and currency crash) is that they did not have their own sovereign currency. In this case, having strong countries in addition to weaker ones helped in stabilizing the currency and not let it take a free fall (even though it had been depreciating over time).

Did these countries deserve to find themselves in such situations? Most likely yes, yet, in most of the times the punishment was much worse and much more prolonged than the sins committed. Knowing the above would have made it easier on the citizens of each country. Summing up, we have had the opportunity to learn from this crisis. Yet, as already said, whether we are willing to do so and whether we will not repeat such mistakes when we may be forced to face similar trouble is something that is completely up to us.

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