A Barrage of Keynesian Advice for Europe

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Includes: DIA, SPY
by: Acting Man

NYT Fires Double-Barreled Shotgun

No sooner had the virtual ink dried on our rant about the false dichotomy between "growth" and "austerity" yesterday, when the NYT countered by firing off the sawed-off double-barreled one, presumably in the hope that if they sprayed their pellets around in a wide enough area, one or two might accidentally hit the mark.

Alas! No such luck.

It started out with a few paragraphs of Krugman soundbites, which as one commentator observed raised the question of how many times Krugman was going to write the same article over and over again.

"Death of a Fairy Tale", Krugman's newest missive boldly proclaims, and it is indeed a rehashing of an earlier column bearing a roughly similar title if memory serves. Krugman summarizes the ghastly actions policymakers have allegedly been seduced into undertaking on the advice of heartless text-book deniers:

“This was the month the confidence fairy died. For the past two years most policy makers in Europe and many politicians and pundits in America have been in thrall to a destructive economic doctrine. According to this doctrine, governments should respond to a severely depressed economy not the way the textbooks say they should — by spending more to offset falling private demand — but with fiscal austerity, slashing spending in an effort to balance their budgets.”

How much better would Greece, Ireland and Portugal have fared had their governments just kept spending! Oh, wait a minute, they actually ran out of money to spend. Oops!

Of course Krugman " s little soundbite synopsis above contains a few rather important inaccuracies. Let us first look at America, which according to Krugman has, similar to Europe, been "in thrall to the destructive doctrine" peddled by the evil "textbook deniers". He doesn"t mention which text book, but we know of course which one he means. The one the prescriptions of which would "work best" in a "totalitarian state" according to its author:

“The theory of aggregate production, which is the point of the following book, nevertheless can be much easier adapted to the conditions of a totalitarian state than the theory of production and distribution of a given production put forth under conditions of free competition and a large degree of laissez-faire. This is one of the reasons that justifies the fact that I call my theory a general theory."

This is the "textbook" Krugman wants us to follow. He usually makes it sound as though it were a sacred collection of economic recipes against which no further argument can be brooked. We would note here that we possess quite a large number of text books that make entirely different recommendations than Krugman's favored tome. Let us however look how his assertion about the evil text book deniers stacks up relative to what is commonly referred to as "reality".

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The absolute level of federal debt increased by more than 50% in four long years and roughly tripled over the past decade. Using the past decade to merely spend twice as much as in all of preceding history is a clear sign that destructive doctrines of miserly tightfistedness are holding the government back from doing what it must do. Obviously, things would be much better if more had been spent - just ask the Greeks - click chart for better resolution.

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U.S. government deficit as a percentage of GDP

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Total public debt as a percentage of GDP

So, somehow Krugman must have missed what happened over the past four years in the United States with regards to deficit spending and the growth of the public debt. Or maybe he means they just didn ' t spend enough?

So what about those tightwads in the euro area? Have they been spending less? The total euro area government debt in euro terms at the end of 2007/beginning of 2008 was at € 5.985 trillion, or 66.3% of GDP.

It was clocking in at € 8.215 trillion as at the end of 2011, or 87.2% of GDP.

And the euro area wide annual budget deficit? That was € 60 billion at the end of 2007, or 0.7% of GDP. At the end of 2010 this had risen to € 571 billion, or 6.2 of GDP.

Some austerity!

In 2011 the data finally seemed to turn for the better, with the deficit falling to 4.1% of GDP euro area-wide, or € 388 billion – an inevitable result of several nations simply going bankrupt in the meantime.

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Euro area government debt as a percentage of GDP – in absolute numbers, there was an increase of €2.23 trillion between early 2008 and end of 2011, or 37.26% in four years.

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Euro area government deficits as a percentage of GDP until end 2010 – the somewhat better data point of minus 4.2% in 2011 has not yet been added to this chart. Although 'better' than 2009 and 2010, it is still the third worst deficit of the entire period since the euro was adopted.

Now, on account of several countries going effectively bankrupt in the euro area since late 2010, the deficit has become slightly smaller in 2011. It still was the third biggest deficit since the introduction of the euro, with only 2009 and 2010 producing worse figures.

So we must now ask: where is Krugman's evidence? As far as we can tell, all that has happened in the euro area was that taxes have been raised, which incidentally is a policy Krugman supports at every opportunity. The bankrupt nations like Greece have lowered their deficit spending but have not truly 'slashed' it, with the result that the value of their outstanding debt continued to mount (in Greece's case there was a big one time cut due to the PSI deal in the meantime).

However, we're not even sure what Krugman actually wants them to do. You can't spend money you don't have if no-one wants to lend more to you. It's as simple as that. There's not even anything worth debating.

Krugman continues:

Critics warned from the beginning that austerity in the face of depression would only make that depression worse. But the “austerians” insisted that the reverse would happen. Why? Confidence! “Confidence-inspiring policies will foster and not hamper economic recovery,” declared Jean-Claude Trichet, the former president of the European Central Bank — a claim echoed by Republicans in Congress here. Or as I put it way back when, the idea was that the confidence fairy would come in and reward policy makers for their fiscal virtue.

The good news is that many influential people are finally admitting that the confidence fairy was a myth. The bad news is that despite this admission there seems to be little prospect of a near-term course change either in Europe or here in America, where we never fully embraced the doctrine, but have, nonetheless, had de facto austerity in the form of huge spending and employment cuts at the state and local level.”

Now let us first of all note here that it takes time for the investment errors of a major boom to be corrected. However, it takes even more time than it otherwise would when the government goes on a deficit spending spree and the central bank inflates like there's no tomorrow – which is exactly what has happened thus far in the US and to a smaller extent in the euro area.

Krugman is asking the wrong question – he should actually ask how it comes that the policies he recommended have not worked. Not only is the US public debt about 55% higher today than at the beginning of 2008, but the true money supply has been increased by roughly 60% as well. How can anyone argue that the government has not hewed to Krugman's Keynesian advice? The argument seems totally absurd.

Next let us counter the idea that 'stopping the stimulus measures will be a mistake'. This is a rather bizarre stance to adopt. After all, the Keynesians insist that the interventions they recommend will eventually create a 'self-sustaining recovery'. So at what point have we reached this happy state affairs? All we ever hear from them is that we're 'not there yet'. In Japan this song and dance has been heard for 23 years running. So we ask, when is it going to be enough?

We can actually answer this question: never.

The reason is that by "papering over" the downturn with bailouts, money printing and deficit spending, the government has created the foundations of the next major bust. Here is a comparison chart by Michael Pollaro that shows how the current money supply expansion stacks up against those seen in the last two artificial credit-induced booms:

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A chart by Michael Pollaro, comparing the growth of the broad US true money supply TMS-2 over the past two major boom periods and the post-2008 period.

As Pollaro notes in the excellent article that contains the above chart (we recommend reading it in its entirety, but the excerpt below conveys the salient point):

“To Austrians, ALL economic “booms” founded on monetary largesse ALWAYS end in economic busts, roughly equal in size and intensity to the preceding booms. By distorting interest rate and price signals and, as a consequence, creating malinvestments that must eventually be liquidated, monetary booms NECESSITATE economic busts. This is true regardless of whatever short-term benefits the economy and/or financial markets appear to enjoy from this largesse. And whether that largesse originates via the creation of central bank base money (through central bank asset purchase and/or loan programs) or via bank-issued on-demand deposit liabilities in excess of bank reserves or what Austrians call uncovered money substitutes (when said banks are making loans and/or purchasing assets), in the end the result is always economic busts.”

These graphics speak volumes. Now in its 44th month, the Bernanke monetary boom as measured by our TMS2 metric is up a cumulative 58% and tracking the now infamous Housing Boom-Bust monetary surge almost to a tee. Heck, at $3.1 trillion the Bernanke monetary boom is already 1.6 times the size of the monetary surge that produced the Housing Boom-Bust and a whopping 4.5 times the size of the surge that gave us the Tech Boom-Bust. What’s even more interesting is that the Bernanke monetary boom is still going strong. As noted above, the latest TMS2 reading shows it was sporting a 14.5% year-over year rate of increase versus the 9% and decelerating year-over-year rate seen in the 44th month of the Housing Boom-Bust cycle.

We think this kind of monetary largesse guarantees an economic bust. In fact, given the size of the monetary surge so far, it’s quite possible that the bust will rival the size and intensity of Housing Boom-Bust turn Great Recession. Worse still, we could be looking at something even bigger than that …”

(emphasis added)

In other words, we are now already in a situation where the choice will eventually come down to whether another major bust should be allowed to play out or if we want to continue the current policies until the eventual destruction of the underlying currency system has been 'achieved'. According to Krugman, such consequences don't exist, but in the real world they unfortunately do. If that were not so, Zimbabwe would have become a Utopia of riches under Gideon Gono's wise policy.

Krugman continues then by once again distorting the truth, in spite of the fact that he should know better by now (a great many people have pointed the errors he repeats below out to him – there is simply no longer an excuse for continuing to quote this propaganda. The fact that Krugman apparently does so knowingly tells us much about his character).

“So, about that doctrine: appeals to the wonders of confidence are something Herbert Hoover would have found completely familiar — and faith in the confidence fairy has worked out about as well for modern Europe as it did for Hoover’s America.

All around Europe’s periphery, from Spain to Latvia, austerity policies have produced Depression-level slumps and Depression-level unemployment; the confidence fairy is nowhere to be seen, not even in Britain, whose turn to austerity two years ago was greeted with loud hosannas by policy elites on both sides of the Atlantic.”

He has apparently decided to remain in error over Hoover. Hoover ran what was then the biggest peace time deficit ever in US history, he urged businesses to keep wage rates artificially high, which predictably led to soaring unemployment and meddled in all sorts of aspects of the economy, from signing Smoot-Hawley to raising a plethora of taxes. In short, he was precisely the type of interventionist favored by Krugman. It is a matter of record that the FDR administration's "New Deal" was merely regarded as a 'continuation of all the policies started by Hoover'. As Thomas Brewton writes:

“What are the facts, fully detailed and documented by commentators writing at the time.

President Herbert Hoover was a leading exponent of socialist-progressivism in government, despite his characterization by liberal historians as a laissez-faire conservative. So much so that Austrian School economists date the inception of the New Deal to the inauguration of Hoover in 1929. Much of what President Franklin Roosevelt did with disastrous results, from 1933 until late 1940, was merely a continuation and expansion of President Hoover’s policies.

The problem was, not that Hoover was a laissez-faire conservative, but that his liberal-progressive policies failed miserably, just as President Roosevelt’s did from 1933 until the outbreak of World War II.

Socialist supporters of President Roosevelt’s New Deal had to do something to differentiate his identical policies from those of President Hoover. To do so they resorted to the Soviet Union’s standard tactic of rewriting history …”

In addition, it is quite funny that Krugman mentions Latvia as somehow 'proving' that austerity policies have failed. It may not hurt if he did a little bit of fact-checking from time to time one would think.

After a very tough 2008-2010 period, during which Latvia underwent a massive purge of malinvested capital, it has become one of the faster growing economies in Europe. And it concurrently sports a fairly low public-debt-to-GDP ratio in the European context (about 44.7% as of 2010). Now, we will admit that all is certainly not well yet in Latvia, but it is hardly providing empirical confirmation of Krugman's contentions. Moreover, Estonia, which underwent a similarly stringent bust with wage and price declines, grows even faster nowadays and sports a public-debt-to-GDP ratio in the single digits.

As to the assertion that Britain is hewing to an "austerity regime", that is simply utterly ludicrous. The meaning of so-called "austerity" in this context is not "let us spend less", it is "let us increase spending at a slightly slower rate than we otherwise would". This continued massive deficit spending in the UK is accompanied by generous gobs of money printing on the part of the BoE – with the result that the UK is now back in recession.

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Latvia has lately been sporting annualized GDP growth rates between 5 and 6%. Hardly proof that austerity failed to work there.

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Estonia has done even better. It is a nice problem to have in Europe when one must state: "our growth has slowed to 4.5%".

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Somehow all this growth was possible with a public-debt-to-GDP ratio in the mid single digits. A virtual impossibility according to Krugman.

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"Austerity", UK-style. Not spending enough? How about the BoE's ongoing QE money printing programs? Not printing enough?

Krugman continues:

“None of this should come as news, since the failure of austerity policies to deliver as promised has long been obvious. Yet European leaders spent years in denial, insisting that their policies would start working any day now, and celebrating supposed triumphs on the flimsiest of evidence. Notably, the long-suffering (literally) Irish have been hailed as a success story not once but twice, in early 2010 and again in the fall of 2011. Each time the supposed success turned out to be a mirage; three years into its austerity program, Ireland has yet to show any sign of real recovery from a slump that has driven the unemployment rate to almost 15 percent.”

However, the problem with all of this is: the policies pursued in Europe are not free market oriented policies. Ireland indeed isn't doing all that well, although the credit markets nowadays treat it as a manageable problem. But there is only one reason why this should not be a surprise: Ireland has bailed out the banks instead of letting them go bust. It has nothing to do with "austerity" as such, which in any case involves very little cutting of government spending in the euro area: instead it involves mainly the raising of taxes.

Moreover, Krugman's assertion that European leaders are insisting that the "policies would start working any day now" is a brazen misrepresentation. They are definitely not saying that – instead they all point out that these things take time.

In the early 2000's Krugman wrote a screed entitled "Why Germany Kan't Kompete" (sic), accusing Gerhard Schroeder's government of botching economic policy. Today Schroeder's labor reforms are widely credited with the restoration of Germany's competitiveness. So here was another instance of Krugman simply missing the boat, or failing to have the patience to wait and see whether a certain course of policy would or wouldn't work. That he seems completely unable to grasp why certain policies do and others don't work on theoretical grounds is a different matter: it is after all Krugman himself who constantly invokes the 'data'. In short, he should at least concede that empirical confirmation of his contentions remains just as elusive as credible theoretical proof.

Romer Up to Bat As Well

The second barrage was an article by Christina Romer in the NYT on the same day. She at least lays out the measures she thinks should be taken in more detail. Krugman is by comparison crude – he always just calls for more spending and more money printing.

Consider though how her jeremiad begins:

“EUROPEAN policy makers just don’t get it. To hear them talk, you’d think that Europe was on the right path. Troubled countries just need more of the same, they say — more fiscal austerity, more labor market flexibility, more price stability — and the European crisis will be licked.

Have they looked at their own numbers? It has been two years since moves to austerity started, but the crisis is still with us. Growth in European gross domestic product was negative in the last quarter of 2011. Unemployment in the entire euro zone in February was 10.8 percent; in Spain it was an astounding 23.6 percent. And judging from the renewed turbulence in bond markets, investors don’t believe that prosperity is just around the corner.”

(emphasis added)

One almost feels inclined to say "so what"? The emphasized sentence above makes it sound – by inference – as though 'sound money and labor market flexibility' were bad things. And there we thought the reason why Germany is outperforming everyone in Europe now is precisely because of its new-found labor market flexibility. We won't go as far as claiming that it has anything resembling "sound money".

The problem is that Romer and Krugman both are in fact mostly busy attacking straw-men. There is neither sound money, nor is there less government spending in Europe, except where there is no longer any choice due to the bankruptcy of the governments concerned.

Romer continues:

“Fiscal austerity is normally a sensible response to a loss in confidence in a country’s solvency, as has occurred in parts of Europe. But the current situation is exceptional. Short-term interest rates are very low, so large rate reductions to offset the negative impact of budget cutting are impossible.

In addition, the troubled countries of Europe are part of a common currency area. This means that the other obvious tool for stimulating growth during a time of fiscal austerity — depreciating the currency relative to that of their main trading partners — is not available, either.”

Well, good grief, what year is this? 1730? Since when can anyone "devalue" himself back to prosperity? The concept is so utterly absurd it seems hardly worth discussing. But Mrs. Romer was once leading the president's council of economic advisers, is an economics professor in Berkeley and well respected as an economist in mainstream circles.

Obviously, devaluation merely means that your money is worth less than previously. And how can one lower its value relative to other monies? There is only one way: one must inflate.

As Ludwig von Mises wrote on the devaluation policy in Human Action:

“If one looks at devaluation not with the eyes of an apologist of government and union policies, but with the eyes of an economist, one must first of all stress the point that all its alleged blessings arc temporary only. Moreover, they depend on the condition that only one country devalues while the other countries abstain from devaluing their own currencies.

If the other countries devalue in the same proportion, no changes in foreign trade appear. If they devalue to a greater extent, all these transitory blessings, whatever they may be, favor them exclusively.

A general acceptance of the principles of the flexible standard must therefore result in a mutual overbidding between the nations. At the end of this race is the complete destruction of all nations' monetary systems.

The much talked about advantages which devaluation secures in foreign trade and tourism, are entirely due, to the fact that the adjustment of domestic prices and wage rates to the state of affairs created by devaluation requires some time. As long as this adjustment process is not yet completed, exporting is encouraged and importing is discouraged. However, this merely means that in this interval the citizens of the devaluing country are getting less for what they are selling abroad and paying more for what they are buying abroad; concomitantly they must restrict their consumption.

This effect may appear as a boon in the opinion of those for whom the balance of trade is the yardstick of a nation's welfare. In plain language it is to be described in this way: The British citizen must export more British goods in order to buy that quantity of tea which he received before the devaluation for a smaller quantity of exported British goods.

The devaluation, say its champions, reduces the burden of debts. This is certainly true. It favors debtors at the expense of creditors. In the eyes of those who still have not learned that under modern conditions the creditors must not be identified with the rich nor the debtors with the poor, this is beneficial. The actual effect is that the indebted owners of real estate and farm land and the shareholders of indebted corporations are helped to the disadvantage of the enormous majority whose savings are invested in bonds, debentures, savings-bank deposits, and insurance policies.”

(emphasis added)

Romer then goes on to detail her own "Augustine of Hippo" plan for European public spending: cut it, but not now. Make the spending cuts "back-loaded" – this is a synonym for "never", although she asserts that similar plans have been tried and have 'worked' in the past. Color us highly skeptical – usually one must look at all the market data that have accompanied such miracles in order to see what was really behind them. More often than not it was a good dose of monetary inflation and the resultant asset bubbles.

She also has a number ideas for the ECB as one might imagine ("better plans" than those the central planners already implement). Just about the only proposal of hers that we can agree with to a certain extent is the recommendation for Germany to cut its taxes. However, such tax cuts should always be accompanied by commensurate spending cuts, otherwise they are a sham – they will be nothing but deferred taxation.

We are struck by the fact that all these plans aim at instant gratification. What if that is simply not possible? Why should we be surprised Spain is still in crisis when it is well known it went through the biggest real estate and CRE credit bubble ever? Should we not accept that correcting such massive investment errors will take time and that realize the best way to tackle problems like high unemployment is to liberalize the labor market and liberalize the economy more generally?

We are also struck by the fact that the bailout policies are not mentioned anywhere – remember, the crisis began with several countries deciding to bail out their insolvent banks and make them into zombies. Now we are at a juncture where it is increasingly difficult to make the best of what is already a very bad situation. It is a sure bet though that more deficit spending is not going to solve anything.

Addendum: Spanish and Italian Banks Load Up Further on Government Bonds

Reuters reports that the stricken banks in Italy and Spain continue to prop up the debt of their sovereigns:

“Banks in Italy and Spain stuffed their coffers with government bonds last month, European Central Bank data showed on Monday, in the latest sign they have been using ultra-cheap three-year ECB funds to stock up on sovereign debt.

Italian banks now hold more government debt than lenders in any other country in the euro zone, and Monday's data may add to concerns that banks there and in Spain are becoming ever more wedded to the fate of their own heavily indebted governments.

The data, the first for the period following the ECB's huge injection of three-year cash on February 29, showed Italian banks increased their holdings of securities issued by euro zone governments by a record 23.7 billion euros, taking their total holdings to 323.9 billion euros.

Spanish banks boosted their holdings of securities issued by euro zone governments by a hefty 20.1 billion euros. While the rise was smaller than January's record 23 billion, it left total sovereign holdings at a record 263.3 billion euros.

'This confirms that most of the buying that pushed down yields in these two countries was done by the domestic financial sector," Unicredit economist Marco Valli said. "However, as time goes by, the effect of the 3-year money will start to weaken … the willingness to get further exposure is lowering."

Valli also said it was unlikely the ECB would rush back to bond markets via its bond-buying program because bond yields have not climbed high enough to spur the central bank to restart the program.

In the last four months, Spain's banks have bought a net of more than 80 billion euros worth of government paper, while Italian lenders have added almost 70 billion in the past three months.

Spanish 10-year bond yields have fallen back below 6 percent in recent days while Italian 10-year yields are hovering above 5.5 percent. Separate ECB quarterly data on Monday showed that Spanish banks have added considerably to their holdings of their own country's bonds.”

Well … good luck boys. In spite of all this buying, CDS spreads and bond yields on Italy and Spain are nothing much to write home about:

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5 year CDS on Portugal, Italy, Greece and Spain. Spain and Italy are not too far from their all time highs.

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10 year government bond yields of Spain, Italy. Portugal and Greece. This have fared a bit better, relatively speaking, but still not very convincingly so in view of the above mentioned flood of buying.

Addendum 2: Robert Wenzel's Speech to the FRB:

For those of our readers who haven't seen it yet, do yourselves a favor and check out Robert Wenzel's recent speech to the New York Federal Reserve.

Charts by Tradingeconomics, St. Louis Fed, Bloomberg, Michael Pollaro