Tuesday, August 17, 2010

Debt Deflation

(Deflation - fall in prices, negative inflation rate)
With deflation, the real value of debt increases, even if the debt stock remains the same.
Thus in a period of deflation, the proportion of debt in an economy tends to grow, making it increasingly difficult to get on top.

As soon as the ECB embraced austerity measures with an unbridled enthusiasm, I was worried about the future of the European economy. In particular I was worried that the ECB looked upon the economic problems of the EU as being one dimensional. It seemed the only real problem was that countries had borrowed too much and that if these profligate countries could just implement savage spending cuts, increase taxes and cut wages all would be well and the bond market would be happy again.

Back in May, I felt the ECB needed to be offering much more than this approach of just inflicting pain on economies. (see: Euro depression)

Ireland is an example of a country which has embraced austerity with a zeal that would please the most strict Benedictine monks. Spending cuts of 20%, wage freezes. On the positive side, Irish exports have started to become more competitive and they have benefited from being able to export outside the Eurozone area. But, rather shockingly, Irish politicians are realising that you can implement all these spending cuts, but, the deficit just continues to get bigger! No one in the ECB told them that is what could happen.

The savage austerity has led to a rise in unemployment to over 13%. Tax revenues keep falling short, debt as a % of GDP is continuing to rise, and is forecast to be at 96% of GDP by the end of next year. This is the problem of debt deflation. With a fall in nominal GDP, the proportion of debt in the economy continues to grow, making it very difficult to get on top of the debt problem.

The austerity is not wholly without benefits, the Irish economy is very painfully becoming more competitive, but, it is at a high price.
Unemployment reached 13.7pc in July, eating into the tax base. Income tax revenue was down 9pc from a year ago. Ireland’s internal economy (GNP) has shrunk by 20pc in nominal terms -- part deflation, part recession -- as the debt stock rises. The IMF expects public debt to rise to 96pc of GDP by the end of next year. The candle is burning at both ends. Such is the deflation curse, all too familiar to any student of debt dynamics in the 1930s.

From a good, if somewhat depressing article here, about the EU strategy for dealing with debt crisis - suggesting it may be worse for southern European economies. (Telegraph Ambrose-Evans)
We have all heard of a carrot and stick approach. Here the stick is spending cuts to reduce the deficit, but, what the ECB lack is a carrot to maintain economic growth. Usually, the IMF would never recommend such deep spending cuts, without some monetary easing - e.g. devaluation, cutting interest rates, monetary easing, (Anyone in ECB heard of Quantitative easing?). Here the Eurozone countries are facing spending cuts without any counter policy to boost growth.

This is also increasingly an issue for UK economy. Our coalition government keeps telling us the number one priority in the UK economy is deficit reduction. I hope they are learning that slashing spending is not guaranteed to reduce the deficit, if you create deflation and recession into the bargain.

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