Twilight of the Technocrats: Ireland, Italy, and Austerity
This post was written by Stephen Kinsella
Here’s a long-ish opinion piece I wrote for Foreign Affairs.
Let’s define austerity as a sharper than expected drop in government expenditure and a sharper than expected increase in taxes by a government experiencing a large budget deficit. To date there have been about 21 billion euros in austerity measures enacted in Ireland, with about the same amount to come in the future, and not a single riot.
The scale of austerity in Ireland must give Foreign Affairs readers pause. At the scale of the United States economy, this is the equivalent of shutting down the US Department of Defense. Italy is facing into a period of austerity as well. What can they expect?
On the first of November this year Ireland paid €730 million to unsecured senior bondholders of the now-defunct Anglo Irish Bank. On November the 16th Ireland, a country with 4.58 million people, will see €750 million worth of cuts to public services, followed quickly by a cut of €755 million in planned capital expenditures, and €700 million in social welfare cuts.
All told the correction will be close to €2.2 billion euros in a two-week period. The 2.2 billion `adjustment’ will form part of a 3.8billion hair-shirt budget in December designed by technocrats at the EU and IMF to reduce the budget deficit to 8.6% of gross domestic product in 2012.
Readers probably know that Ireland’s gross domestic product was around 160 billion euros last year. Ireland’s gross national product, which nets out the effect of the large multinational presence and their transfer pricing activities in Ireland, was around 130 billion euros last year. The national debt will be paid down by the domestic economy, and the austerity measures felt in the domestic economy, not by a multinational paying less tax by moving the profits from a toaster sale in Texas to Ireland. So we must look a little deeper than gross domestic product figures to see what’s really going on.
Tom Waits once wrote that “the large print giveth, the small print taketh away”. Ireland’s gross domestic product is growing again this year, buoyed by exports, and exports alone. Look beneath the large print of the distorted gross domestic product figure, and things are not looking so good for the Irish economy relative to the rest of the Eurozone.
Eurozone private consumption is expected to rise by 1.4 %, while Ireland’s will grow by 0.6 %. The Eurozone’s governments will be increasing spending on public services by 0.1% while Ireland will be cutting spending by 3.1 %. Since 2007, investment as measured by gross capital formation in Ireland has fallen by 74 %, while in the Eurozone it has fallen 11%. In the Eurozone investment will grow this year by 3.4 % while in Ireland it will grow by 4.8 %, but this is mostly replacement of depreciating capital. In 2013, unemployment is expected to be 10 % overall in the Eurozone while in Ireland it is expected to be above 14%. Right now Ireland’s unemployment rate is 14.4%, some 447,400 people out of a workforce of 2.2 million people.
Now let’s look at Italy, the next country after Greece to contemplate serious austerity measures. Why does it need them? Unlike Ireland, Italy has had no spectacular asset boom and bust; no rash blanket guarantee of banking liabilities (€460 billion worth guaranteed by an economy with €130 billion in domestic output); no costly bank bailouts; no fiscal stains to be cleaned by years of taxpayer indulgences. Italy just hasn’t grown.
Ten years ago, on the eve of the introduction of the Euro, Italy’s ratio of national debt to gross domestic product was 121.6%. In 2011 that ratio is 119%. On average over the last 10 years, Italy’s budget deficit has been around 3.5%, this year is will be 4.5%. No, Italy’s problems essentially come from a decision by the markets that its debt levels of around €1.6 trillion, combined with a possible rollover of that debt of nearly €350 billion, were unsustainable. The problem is a change in perception. This change in perception cost Silvio Berlusconi his job. This change in perception happened to Ireland in May of 2010, when market concerns about the solvency of Greece spilled over and sent the cost of Ireland’s borrowing soaring. Italy’s future is written in Ireland’s history in some respects, but the key change was the perception of investors.
The financier and philosopher George Soros has a theory for such events. The theory of reflexivity says that we are imperfect beings exercising a cognitive function to try to understand the world. We also have a participating function that tries to change the world we are in. These two functions interfere with one another. People must act today based on facts about yesterday and beliefs about tomorrow. There are balancing and competing feedback loops between the two functions.
Think about buying an Italian government bond. You try to understand the market the stock is in, you have past data and future expectations (or more accurately: hopes), and you buy the bond. In buying the bond you change the market. Soros argues that reflexive situations occur where a lack of correspondence between participants’ views and the actual state of affairs exists.
Looking at our bond example, people buy and sell those bonds in anticipation of future prices, but those prices are contingent on investor’s expectations. The `fundamentals’ of the market are just the average of people’s biases. Investor perceptions change these fundamentals. Transitions between widespread agreement on fundamentals cause crises. Leverage, and eventually, austerity, or printing money, to pay down that leverage is the result.
Italy’s growth rate of gross domestic product has averaged 0.5% from 2000 to 2011. The Eurozone average is 10%. Italy’s government has run a persistent budget deficit combined with a higher than normal ratio of debt to gross domestic product for over a decade. Like Ireland, Italy’s exports are growing. So what changed? Why now? The perception of Italy’s risk of default by investors has changed, and nothing more.
Italy’s technocratic new Prime Minister Mario Monti has pledged to enact austerity measures. Italy’s sclerotic pension system will have to be reformed; public sector hiring will be reduced, as will public sector pay; there may be a move to temporarily block those set to retire; and the government may reduce funding to local government. Taxes will rise. Italy will follow Ireland, Portugal, Spain, and Greece in imposing austerity on its citizens to appease funding concerns that have become, suddenly, the norm.
What is the role of the European Central Bank in all this? Again, the large print giveth, and the small print taketh away. US readers will expect the ECB to behave much like the Federal Reserve has during the crisis, printing dollars, cleansing banks’ balance sheets, and issuing bonds. They are mistaken, but only because they are looking at the large print. The European Central Bank is not a Central Bank. It is a coordinating currency board with added bells and whistles.
The European System of Central Banks is a net of national central banks that coordinate their activities through the central hub of the European Central Bank. The paralysis at the European Central Bank is caused by the inability of the German, French, Italian and 24 member states national banks to agree on a common set of policies during the crisis. Of course German interests trump other nations’ interests in practice, which is why the ECB is suffering from a curse of credibility when it comes to its response to the crisis. The ECB, essentially the Bundesbank and Friends, will not sacrifice the credibility of the currency board to behave as the Federal Reserve has during the crisis. And so, deprived of the natural backstop of monetary policy, the only other option to resolving the crisis is fiscal policy, incarnated as austerity measures for the unfortunate member states who find themselves at the mercy of the bond markets’ perceptions.
Why can’t the ECB step in as lender of last resort, Fed-style, and rescue the banks and nation states? The answer given is legal. The Maastricht Treaty which established the ECB mandates it under article 104 of that Treaty to pursue price stability and general financial stability. Obviously price stability is orthogonal to printing money to bail out banks and governments. So case closed? Not exactly. Article 11 of the Protocol on the Statute of the European System of Central Banks (ESCB) and of the European Central Bank actually enables, but doesn’t require the ECB to act as a lender of last resort. The ECB exploits this constructive ambiguity when it suits them to do so: bond buying by the ECB, anathema in 2009, is commonplace today. Lender of last resort facilities could be made available. What is lacking is the political will to do so. The ambiguity may turn destructive if nation states cannot grow due to austerity policies enacted to safeguard the credibility of a currency board.
There are now three technocratic governments in Europe. In Italy, we have Yale-educated economist and formed EU Commissioner Mario Monti’s government. In Greece, we have the government of Lucas Papademos (also an economist and not incidentally a former Vice President of the ECB). In Ireland the Troika of the ECB, EU Commission, and IMF makes all major decisions on fiscal policy, led by IMF economist Ajay Chopra.
The swing away from democracy by the European Union was evident in the reception the recently ousted Greek Prime Minister received when he called for a referendum on austerity measures. The deep irony is not that the EU shouted this down, but that Greek politicians, in the cradle of democracy, balked at asking their people a simple question. This should not go unnoticed.
The round of austerity measures and crisis meetings will continue, with laggard governments pulled into line to return the Eurozone to a semblance of balance. Recent history has shown that technocrats, if necessary, will manage all of this when directly elected politicians can’t or won’t. I wish them well. The twilight of the technocrats will come if they fail. As all politicians know, there is only one end to the holding of power: failure. The technocrats will impose austerity on their peoples, and hope an expansionary fiscal contraction is the result. This may or may not happen, but when the people see the technocrats, who did not foresee the Eurozone crisis, who have dithered as the crisis gathered steam, hold the reins of power for a while, they may become disenchanted with the professors. And what then?