What’s so hard to understand about the word Contractionary?

I just read an excellent article at VOXEU called “A summit to the Death” by Kevin O’Rourke. It’s full of common sense economic analysis about the state of the EU that reminds me of how rare common sense can be.  While the analysis looks at he EU, it could well apply to the US as well.  There seems to be some disease in political bodies these days that cannot grasp the concept of contractionary policy as contractionary.

There’s also this scramble to save financial institutions at all costs while doing nothing to prevent recurrence of bad practices and solving the fall out anywhere outside a bank balance sheet. To a certain extent, the EU crisis comes from the inability of many countries to think of policy in terms of something other than currency devaluation as a way of making their workers and goods appear cheap  to the rest of the world.   In this scenario, a country can goose some of its business activities at the expense of some of its businesses and its citizens and not get caught by any one but those of us that watch those sort of things.   That long run game of devaluing US workers has caught up with us here.

One lesson that the world has learned since the financial crisis of 2008 is that a contractionary fiscal policy means what it says: contraction. Since 2010, a Europe-wide experiment has conclusively falsified the idea that fiscal contractions are expansionary. August 2011 saw the largest monthly decrease in eurozone industrial production since September 2009, German exports fell sharply in October, and now-casting.com is predicting declines in eurozone GDP for late 2011 and early 2012.

A second, related lesson is that it is difficult to cut nominal wages, and that they are certainly not flexible enough to eliminate unemployment. That is true even in a country as flexible, small, and open as Ireland, where unemployment increased last month to 14.5%, emigration notwithstanding, and where tax revenues in November ran 1.6% below target as a result. If the nineteenth-century “internal devaluation” strategy to promote growth by cutting domestic wages and prices is proving so difficult in Ireland, how does the EU expect it to work across the entire eurozone periphery?

The world nowadays looks very much like the theoretical world that economists have traditionally used to examine the costs and benefits of monetary unions. The eurozone members’ loss of ability to devalue their exchange rates is a major cost. Governments’ efforts to promote wage cuts, or to engineer them by driving their countries into recession, cannot substitute for exchange-rate devaluation. Placing the entire burden of adjustment on deficit countries is a recipe for disaster.

In order to protect financial markets, countries like the UK and the US have been willing to prop up poorly performing financial institutions at an extremely high cost while further driving the nominal wages of their workers to lower and lower levels through currency debasement.  Then, after slashing spending, they wonder why they’re economies don’t expand.  It seems like some of the very easiest lessons of Macro 101 weren’t absorbed by a number of world leaders today. That vehicle of robbing Peter to prop up Paul and a few exporters isn’t available to countries in a currency union unless the Central Bank wants to do it for all.

O’Rourke’s analysis led Paul Krugman to rightly make this observation.

Maybe it was always thus, but the relentless wrong-headedness of the Europeans, their insistence on seeing their crisis as something it isn’t, and responding with actions that deepen the real crisis, has been a wonder to behold. In the 1930s policy makers had the excuse of ignorance; there was nobody to explain what was happening. Now, their actions amount to a willful disregard of Econ 101.

Let me provide an interesting bit of perspective. In 2007, Spain ran a budget surplus. That actually was its third budget surplus in row. At the time, its growth had been forecast to decline but ot was slammed by the global financial crisis. Spain is now on the list of problem countries–the S of the PIIGS–because it was trying to deal with 30 years of budget deficits to get in line with the EU Criteria. Balanced budgets are the proscribed way to handle an economy that is operating where it should be operating. Spain’s is having problems because financial institutions all over the world gambled and lost. Their economic activity declined, their tax receipts went down, and their obligations to the unemployed went up. So, as would be expected, their deficits widened.  Now, the banks that caused the huge global crisis are getting full court sympathy and Spain is being blamed for threatening the status of the union.

Here’s another Krugman blogpost which shows Olympia Snow basically arguing something that is ridiculous in the face of such a huge global economic decline. It’s the same kind of ridiculous thinking in European policy making ciricles.  There just seems to be a rampant misunderstanding of basic economics by many policy makers. What don’t they get about contractions and their relationships to deficits? Snowe calls fiscal shenanigans on something that’s just basic economic math and actually calls for policies that will just make the math worse.

A nation that can borrow at negative real interest rates isn’t exactly facing a debt crisis. We do have a $15 trillion debt — but that debt reflects a combination of (1) permanent tax cuts, not paid for at all (2) large temporary spending on wars, not paid for at all, and (3) a severe economic crisis, which has depressed revenue (mainly) and required some emergency spending (which accounts for only a small piece of the debt)

And another thing: short-term outlays offset by long-term austerity is precisely what macroeconomics 101 says you should do when faced with a depressed economy. It’s not “shenanigans”, it’s orthodox macro and the height of responsibility.

The best way out of a terrible economy is to robustly grow your economy.  You don’t grow your economy by killing government programs and spending then ensuring the wages go down on the majority of your population who actually spend money on day-to-day things produced in your economy. It just doesn’t get an more common sense than that.   Handing over trillions of dollars to banks for them to sit on or make arbitrage bets to earn paper profits isn’t a strategy to grow your economy. Deliberately removing workers from government payrolls and placing their spending in jeopardy while wishing for job creation isn’t an economic strategy.  It’s a recipe for disaster. It’s not only our recipe for disaster but the recipe for disaster in Europe too. Look at this simple explanation from O’Rourke coincidentally using something that’s near and dear to my heart as an example, Louisiana Gumbo.

If the gumbo industry goes into decline, driving the US state of Louisiana into a recession, residents will pay fewer federal taxes and receive more fiscal transfers. These financial flows are a natural counter-cyclical mechanism that helps local and regional economies to weather bad times. In a hypothetical European fiscal union, there would certainly be transfers from Germany to the periphery in 2011, but a properly designed setup would have ensured flows toGermany in the 1990’s, as it struggled to cope with the costs of reunification with East Germany.

With this in mind, the most obvious point about the recent summit is that the “fiscal stability union” that it proposed is nothing of the sort. Rather than creating an inter-regional insurance mechanism involving counter-cyclical transfers, the version on offer would constitutionalize pro-cyclical adjustment in recession-hit countries, with no countervailing measures to boost demand elsewhere in the eurozone. Describing this as a “fiscal union,” as some have done, constitutes a near-Orwellian abuse of language.

For some reason, the current crop of politicians continues to confuse a government with households and businesses. They also encourage low information voters to do the same  Governments did not hesitate to use their powers to borrow, spend, or print money when it came to handing over trillions to banks or war efforts. Why  do they completely forget the powers and the perpetuity of government when it comes to using that same power for solving economic problems for communities, regular size businesses, and just plain folks?  It’s just terribly frustrating to have  to watch all of this knowing full well that there are fairly straightforward solutions.  They seem only to be capable of promoting long expensive wars, massive monopolistic corporations, irresponsible financial mishap, and ruin for the ordinary person.  Then, they make speeches like Senator Snowe that just provide basic fairy tales to low information voters.  It’s distressing.  It’s like being a doctor watching people in charge of things bleed patients to solve their anemia.