If Reinhart and Rogoff’s ‘error’ has discredited the prevailing policy dogma, now is the time for an alternative that works
The intellectual justification for austerity lies in ruins. It turns out that Harvard economists Carmen Reinhart and Ken Rogoff, who originally framed the argument that too high a “debt-to-GDP ratio” will always, necessarily, lead to economic contraction – and who had aggressively promoted it during Rogoff’s tenure as chief economist for the IMF –, had based their entire argument on a spreadsheet error. The premise behind the cuts turns out to be faulty. There is now no definite proof that high levels of debt necessarily lead to recession.
Will we, then, see a reversal of policy? A sea of mea culpas from politicians who have spent the last few years telling disabled pensioners to give up their bus passes and poor students to forgo college, all on the basis of a mistake? It seems unlikely. After all, as I and many others have long argued, austerity was never really an economic policy: ultimately, it was always about morality. We are talking about a politics of crime and punishment, sin and atonement. True, it’s never been particularly clear exactly what the original sin was: some combination, perhaps, of tax avoidance, laziness, benefit fraud and the election of irresponsible leaders. But in a larger sense, the message was that we were guilty of having dreamed of social security, humane working conditions, pensions, social and economic democracy.
The morality of debt has proved spectacularly good politics. It appears to work just as well whatever form it takes: fiscal sadism (Dutch and German voters really do believe that Greek, Spanish and Irish citizens are all, collectively, as they put it, “debt sinners”, and vow support for politicians willing to punish them) or fiscal masochism (middle-class Britons really will dutifully vote for candidates who tell them that government has been on a binge, that they must tighten their belts, it’ll be hard, but it’s something we can all do for the sake of our grandchildren). Politicians locate economic theories that provide flashy equations to justify the politics; their authors, like Rogoff, are celebrated as oracles; no one bothers to check if the numbers actually add up.
If ever proof was required that the theory is selected to suit the politics, one need only consider the reaction politicians have to economists who dare suggest this moralistic framework is unnecessary; or that there might be solutions that don’t involve widespread human suffering.
Even before we knew Reinhart and Rogoff’s study was simply wrong, many had pointed out their historical survey made no distinction between the effects of debt on countries such as the US or Japan – which issue their own currency and therefore have their debt denominated in that currency – and countries such as Ireland, Greece, that do not. But the real solution to the eurobond crisis, some have argued, lies in precisely this distinction.
Why is Japan not in the same situation as Spain or Italy? It has one of the highest public debt-to-GDP ratios in the world (twice that of Ireland), and is regularly featured in magazines like the Economist as a prima facie example of an economic basket case, or at least, how not to manage a modern industrial economy. Yet they have no problem raising money. In fact the rate on their 10-year bonds is under 1%. Why? Because there’s no danger of default. Everyone knows that in the event of an emergency, the Japanese government could simply print the money. And Japanese money, in turn, will always be good because there is a constant demand for it by anyone who has to pay Japanese taxes.
This is precisely what Ireland, or Spain, or any of the other troubled southern eurozone countries, cannot do. Since only the German-dominated European Central Bank can print euros, investors in Irish bonds fear default, and the interest rates are bid up accordingly. Hence the vicious cycle of austerity. As a larger percentage of government spending has to be redirected to paying rising interest rates, budgets are slashed, workers fired, the economy shrinks, and so does the tax base, further reducing government revenues and further increasing the danger of default. Finally, political representatives of the creditors are forced to offer “rescue packages”, announcing that, if the offending country is willing to sufficiently chastise its sick and elderly, and shatter the dreams and aspirations of a sufficient percentage of its youth, they will take measures to ensure the bonds will not default.
Warren Mosler and Philip Pilkington are two economists who dare to think beyond the shackles of Rogoff-style austerity economics. They belong to the modern money theory school, which starts by looking at how money actually works, rather than at how it should work. On this basis, they have made a powerful case that if we just get back to that basic problem of money-creation, we may well discover that none of this is ever necessary to begin with. In conjunction with the Levy Institute at Bard College, they propose an ingenious, yet elegant solution to the eurobond crisis. Why not simply add a bit of legal language to, say, Irish bonds, declaring that, in the event of default, those bonds could themselves be used to pay Irish taxes? Investors would be reassured the bonds would remain “money good” even in the worst of crises – since even if they weren’t doing business in Ireland, and didn’t have to pay Irish taxes, it would be easy enough to sell them at a slight discount to someone who does. Once potential investors understood the new arrangement, interest rates would fall back from 4-5% to a manageable 1-2%, and the cycle of austerity would be broken.
Why has this plan not been adopted? When it was proposed in the Irish parliament in May 2012, finance minster Michael Noonan rejected the plan on completely arbitrary grounds (he claimed it would mean treating some bond-holders differently than others, and ignored those who quickly pointed out existing bonds could easily be given the same legal status, or else, swapped for tax-backed bonds). No one is quite sure what the real reason was, other than perhaps an instinctual bureaucratic fear of the unknown.
It’s not even clear that anyone would even be hurt by such a plan. Investors would be happy. Citizens would see quick relief from cuts. There’d be no need for further bailouts. It might not work as well in countries such as Greece, where tax collection is, let us say, less reliable, and it might not entirely eliminate the crisis. But it would almost certainly have major salutary effects. If the politicians refuse to consider it – as they so far have done –, it’s hard to see any reason other than sheer incredulity at the thought that the great moral drama of modern times might in fact be nothing more than the product of bad theory and faulty data series.
Olli Rehn hints that Europe’s fiscal cutbacks could be slowed, as the world’s top central bankers and finance chiefs gather in Washington
Bundestag MPs expected to criticise the handling of the Cypriot rescue plan this morning, with a vote expected around 10am BST (11am CET).
China Q1 GDP falls to 7.7% versus expectations of 8%, with industrial production 8.9% against expected 10.1%
Sharon Connor stands to lose upwards of €50,000 after her profits from a house sale remain frozen in a bank on the island
Tragedy first struck Sharon Connor when her husband, Gary, was killed by a heart attack in January last year. He had just turned 54. From running a successful scuba-diving business on Cyprus, the mother-of-two found herself catapulted into a world of grief, unable to even visit the ornate, two-storey villa the couple had bought on the island.
“It took me five months before I could set foot in the place,” said Connor, who was on her own when she found her husband dead in bed. “I still have flashbacks and see it in my head all the time.”
In March the widow decided to put the property on the market. In the space of three days she had found a buyer, located a new home in the UK and a job outside London. “I was trying to move forward with my life,” the 55-year-old told the Observer from Kent, “until I found myself caught up in the nightmare scenario that has befallen Cyprus”.
This weekend the Briton faces the prospect of financial ruin following the shattering news that the proceeds from her house sale – €181,000 (£155,000) – will remain frozen in the Bank of Cyprus as a result of capital controls enforced to contain the crisis.
As the size of Cyprus’s bailout requirements swelled from €17bn to €23bn, she learned that the money, deposited in a special account for the purposes of the transaction, could not be transferred to the UK. Now she lives in fear that, like other depositors with more than €100,000 in Cyprus, she will also fall victim to the raid on savings that the Cypriot government has been ordered to implement as the price of international aid.
“It is totally unfair. My funds should not be frozen, as they are not savings that have been accruing interest,” said Connor, whose misfortune was that the money hit her account two hours before the close of business on 15 March.
“It was money from a real estate sale that was supposed to be in the bank for a single day. The same day it went in, I sent an email instructing the bank to transfer the funds – some of which were in euros and some in sterling – to the UK, but on Saturday morning the news broke that Cypriot banks were in major financial difficulty.”
Ever since then Connor, who was due last week to buy a three-bedroom semi in Kent, has been battling to get her money released. She has written to “everyone who is anyone”, including David Cameron and Angela Merkel, and started a Facebook campaign called “Gary and Sharon v Merkel”.
“Every day is a struggle,” said the widow, who is from Welling in south-east London. “I was set on moving on after Gary passed last year and had everything in motion when, overnight, my world was turned upside down again … it is a scenario that had made me physically ill.”
Connor has calculated that she could lose €50,000 (£42,000) as a result of the emergency levy that Nicosia must now enact to qualify for financial assistance from the EU and the International Monetary Fund. Revelations that the beleaguered Cypriot government will have to find almost double the amount to meet the terms of the €10bn bailout – amid signs that the EU’s wealthy north has tired of rescuing the bloc’s heavily indebted south – have only sharpened her anguish. “Now I live in worry that with the latest news that Cyprus’s bailout requirements are going to be much bigger than thought, depositors will suffer even more,” she said.
Connor had hoped to be exempted from the levy – along with other special cases – but her appeal for dispensation was turned down by the island’s central bank last week. On Friday she was told by the Bank of Cyprus that it was seeking clarification. “I asked my representative at the Bank of Cyprus to put forward my appeal to the central bank, and in turn they asked for the contract of sale and solicitors’ details,” she recalled. “Last week the central bank committee declined the request. I was also told that I cannot transfer any funds from my accounts to the UK.”
In a cruel twist of fate, the sale was due to have been completed a week earlier. “A document was missing from the necessary paperwork that prevented the deal from being closed,” she said. “Had the transaction gone through as originally planned, the funds would now be in my British bank account.”
Connor, who also has five grandchildren, has now been forced to cash in her two private pension schemes to make ends meet. “I have my furniture in storage with no way of knowing when, or if, I can purchase my own property,” she said. “The local council will not put me on their housing register as I have funds from the sale of a house in the bank, albeit I cannot access them.”
Had it not been for the help of friends and family, she says, she might not have got through the ordeal. “If it was not for the goodness of my sister, Theresa, and other family members, I would be homeless,” she said. “I live in hope that common sense will prevail and I will receive what is rightfully mine. This is money that my husband and I have accumulated and worked for our whole lives.”
• Euroland nightmare weighs on UK
• BP and ‘on target’ results
• HBOS hubris
• Lord Green visits Latin America
→It is tempting from a UK perspective to regard events in Cyprus as a case of domestic violence within the eurozone that doesn’t much affect us.
That would be mistake. The serving of “poison” to Cyprus, as the country’s parliamentary president put it this week, amounts to another statement by Germany that the hard way is the right way. There will be no slackening in the austerity message ahead of September’s election, and thus no meaningful debate on how creditors and debtors are going to live in harmony. Minor accidents like Cyprus, it seems, will simply be allowed to happen and eurozone lenders will try to minimise the bill for themselves.
Progress on banking union, supposedly last year’s big step forward, has been negligible and there’s an unfilled hole at the centre. The European stability mechanism (ESM) was intended to deal with insolvent banks, but then it turned out the fund would not deal in “legacy” issues. That’s not an advance.
Thus every bailout remains an ugly scrap in which, as in Cyprus, heroic assumptions are made about recovery and business confidence across the continent is jolted. Is the next crisis Portugal mark 2, or Slovenia? Only then will companies and large depositors discover whether a Cypriot-style savings-grab is the new template.
Add up the austerity, the mixed messages and the backtracking and it’s no surprise that the IMF expects the euro area GDP to contract 0.2% this year, after contraction of 0.4% last year. For the UK economy euro recession is impossible to ignore. “Engineering a recovery while our main trading partner is in a downturn is a difficult undertaking,” said the Bank of England governor, Sir Mervyn King, in January.
You bet. The economy is not rebalancing in favour of manufacturing. Britain’s trade deficit in goods widened to £9.4bn in February, we learned this week, and factory production is back at levels seen last September. A government desperate for growth – any growth – is reduced to trying to pump up the housing market by underwriting sub-prime mortgages. Stagnation and indecision in euroland are infecting not just the economy but economic policy.
Hope springs eternal that Germany, after the election, will finally decide how far it is prepared to go to save the single currency. Well, maybe. But it’s a reasonable guess that markets, currently understanding of Angela Merkel’s political bind, will demand a quick answer. And a post-election mini-revolt in the eurozone debt markets would be no bad thing: the current muddle-through approach is leading nowhere.
→BP’s pay structure, according to remuneration chief Antony Burgmans, employs a “relatively simple” system. Relative to what, he doesn’t say, but it’s a challenge for ordinary mortals to keep track of the moving parts. The annual cash bonus scheme alone has 13 “measures and targets”. Then there’s the deferred bonus, and the performance share scheme, not forgetting basic salary and pension.
Thankfully, somebody is paying attention. He is Guy Jubb of Standard Life Investments, who told the board at this week’s shareholder meeting to “raise its game”. He’s right about the complexity, and he’s also right when he says the executives have the potential to receive “significant rewards for achieving unchallenging performance targets”.
The giveaway is the table that illustrates what chief executive Bob Dudley should receive in a year in which he achieves merely an “on target” performance – a cool $10m (£6.5m), even if the share price went sideways.
How is that possible for a middling performance? It’s because long-term incentive plans (LTIPs) have become vastly inflated over the years. Once upon a time, 100% of salary for an LTIP was seen as the largest carrot that could be offered to an executive. These days Dudley can earn 550% of salary under his LTIP. In cash terms, today’s “on target” performance equates to yesterday’s hit-the-ball-out-of-the-park performance.
Jubb calculates that by merely coming third out of five in a league table of oil companies ranked by total shareholder return (TSR), BP’s chief executive can receive shares equivalent to nearly two-thirds of his $1.7m salary. Third out of five? If BP really believes that’s worthy of a £1m bonus it should drop the pretence that Dudley’s package is driven by tough performance targets.
The company was very pleased that 94% of voting shareholders backed the pay report. The reason for that, one suspects, is that executive payouts from incentive schemes have been depressed by the Deepwater Horizon disaster in 2010. Now that the effect of the disaster on the share price will drop out of the three-yearly TSR calculations, Dudley’s generous rewards for “on target” results are much more likely to materialise.
Complexity and the redefinition of success are how boardroom pay outstripped shareholders’ gains in the past. It’s happening again. BP is probably not unique.
→HBOS famously ignored a cardinal rule of banking: never take an equity stake in a company to which you are a lender. If you do, you are no longer a bank but a private equity house and there’s trouble in store in the event of a restructuring.
Some of HBOS’s early loan-plus-equity adventures turned out spectacularly well, such as Sir Philip Green’s takeover of Arcadia, the Top Shop group, in 2002. But that doesn’t deflect from the wisdom of the basic risk-management principle that lenders should not dabble in the shares of a customer.
Less remembered is how far HBOS was prepared to go. Ray Perman’s lively book – Hubris: how HBOS wrecked the best bank in Britain – recalls the detail of Green’s attempt (eventually abandoned) to buy Marks & Spencer in 2004. In that case, HBOS would have been a major lender in the £9.5bn offer. But the bank’s chairman, Lord Stevenson, was also lined up to be a non-executive director of Green’s bid vehicle. It is hard to think of a more glaring example of a conflict of interest.
Perman reports that arrangement caused one of the few rows within the HBOS board. It also caused a fuss in the outside world at the time, but should have caused more. It was an early clue that HBOS directors had deluded themselves that traditional rules of banking didn’t apply to them.
Finance ministers meet in Dublin to discuss crisis in Cyprus and Slovenia situation – with extensions to bailouts for Ireland and Portugal reportedly on the agenda
The digital currency spikes at $266 before plunging to $105 on Wednesday in wild ride possibly linked to Reddit user
Bitcoin, the digital currency, lost more than $160 (£104) in value on Wednesday, just hours after hitting a record high.
The currency hit a new high of $266 before falling to $105 and then bouncing back to $130. The fall is unlikely to put off speculators. Two months ago, a Bitcoin was worth $20.
With Europe racked by economic uncertainty following the banking crisis in Cyprus, there have been fears that a “bubble” is being created with speculators piling into the four-year-old digital currency. But Bitcoin has crashed before only to bounce back. It hit a low of $7 in August 2011 after hitting a high of $32 two months earlier.
Jon Matonis of the Bitcoin Foundation, the currency’s promoter, denied a euro-bubble was being created in an interview with Der Spiegel this week.
“Most transactions are still coming from affluent regions, like the United States and northern Europe. What we are seeing is not a Cyprus bubble,” he said.
Until recently Bitcoin had been a largely obscure currency used by the tech-savvy, libertarians wishing to thumb their noses at central bankers and people involved in more nefarious activities such as online gambling (often illegal in the US) or drug deals.
There are around 11m Bitcoins in circulation, 25 new bitcoins are produced every 10 minutes, and they are traded through online exchanges like Mt.Gox.
Dealing in the currency is volatile as has been the history of the services that allow people to trade in Bitcoins. Mt.Gox has been subject to repeated hacking attacks. Instawallet, a popular service for storing Bitcoins, had to be suspended after it was hacked.
Many financial experts have warned against Bitcoin. Veteran UBS stockbroker Art Cashin has compared the interest in Bitcoin to the tulip mania that led many to financial ruin in the 17th century. But interest in the currency has shot up as the euro has become ever more embattled. The value of a Bitcoin passed the $200 mark for the first time on Tuesday.
Wednesday’s wild ride came as someone gave away thousands of dollars worth of Bitcoins on Reddit, the social news site. News blog Business Insider calculated a Reddit user under the name “Bitcoinbillionaire” had given away $13,627.69896 worth of Bitcoins to Reddit users over the day. The mystery donor signed off with a quote from Ron Paul, libertarian politician and one-time would-be presidential candidate: “It’s no coincidence that the century of total war coincided with the century of central banking.”
Debt sustainability analysis which leaked last night shows that Cyprus’s contribution to its own bailout has risen from €7bn to €13bn