Arrears

One of the factors that have slowed down Italian growth in the current crisis, even relatively to a sluggish Eurozone, is undoubtedly the endemic accumulation of large scale arrears in Public Administration payments to enterprises for their supply of goods and services to central and local government. True, the very expectation of payment delays tends to be built into enterprise costs and therefore inflate the volume of public expenditure, but even so the build-up of arrears remains a sick anomaly in any market economy, which especially in a tight credit market such as at present can drive even healthy, successful enterprises to lay-offs and bankruptcy.

The very scale of such public arrears is uncertain, which makes it worse. A year ago the Bank of Italy estimated the commercial debt of the Public Administration to be of the order of €90 bn at the end of 2012.  Since then €24 bn have been paid off, but there have been new gross additions to the total. A conservative estimate of current arrears is above €80 bn (La Repubblica, Economia e Finanza, 10 March 2014, p.2) while estimates by the Confederation of Italian Industry put them at as much as €120 bn. Many of the arrears involve off-budget, non-certified expenditures.

The idiosyncracy, not to say the idiocy of the “internal” Growth and Stability Pact constraints, translating Maastricht macroeconomic constraints into local authorities’ microeconomics, often prevents payments even when expenditures are properly budgeted for and finance is available. Anal retention on the part of high officials of the Ministry of the Economy and Finance, also in order to avoid possible accusations of payments breaking European constraints, is an additional factor. But an accounting convention that wholly or partly reckons expenditures and revenues on a cash basis (“bilancio di cassa) rather than on accrual (i.e. including also receivables and payables, as in the “bilancio di competenza”) actually provides an incentive for the Public Administration to obtain, as it were, free credit from enterprises in a way that does not affect adversely its financial performance, regardless of the massive costs inflicted as a result on the economy and its viability and growth.

Clearly from a substantive viewpoint it makes no difference whether the Public Administration owns given arrears to enterprises, or borrows from banks or the financial markets an equivalent amount to pay them off, in which case it does not augment its debt but simply transfers it from the enterprises to new creditors. Financial markets are most unlikely to respond adversely to the Public Administration reducing payments arrears through additional borrowing. But with cash accounting the arrears are not counted as part of expenditure or as a component of debt, whereas the equivalent borrowing does in its entirety. Hence the incentive to let arrears grow.

The popularity of cash accounting belongs to a past in which the control of the  money supply in order to control inflation was a paramount preoccupation at all costs, even if the accumulation of Public Administration arrears towards enterprises involved the collapse of the real economy.

This accounting convention has already made immense damage in the course of post-socialist transition in the early 1990s, when the International Monetary Fund made monthly disbursements to Russia conditional on its respect of cash limits to the state budget deficits, thus encouraging the explosion of arrears owed to enterprises. or owed to state employees, or even to old age pensioners. As the Russians used to say, “Pay As You Go” then meant: First you pay, then you go. Italian so called “esodati”, whose entitlement to pension matured through early retirement was vanified by the sudden rise of pensionable age decreed by the indefensible, unconscionable Minister of Labour Elsa Fornero of the Monti government, could choose this as their motto.

Such an obtuse and nonsensical policy fostered by the IMF in Russia in the early 1990s, in addition to an interest rate positive and large in real terms up to usury levels, and an associated overvalued exchange rate, led to mass unemployment and the parallel accumulation of inter-enterprise debt of the order of 40% of manufacturing enterprises turnover. This de-monetisation of the economy was one of the most important factors in the transformation recession of Russia in the 1990s, which destroyed more than one third of Russian GDP. By the same token the build-up of arrears is one of the factors that took current Italian recession above the European and Eurozone average.

Moreover, accounting conventions differ in Italy and Europe, and for different items of expenditure. Capital account expenditures (perhaps 20% of total arrears, though the precise proportions are also unknown) are always accounted for on a cash basis, both in Europe and in the “internal” so-called Growth and Stability Pact. Current account expenditures (the remaining roughly 80% of arrears), on the contrary, are accounted for on an accrual basis by Europe, and on a cash basis according to the “internal” Pact. Thus past current account expenditures, already accounted by Europe on accrual, can be paid without impacting the European 3% deficit ceiling in the payment year, having been accounted for already in the deficits of past years; whereas capital account payments in 2014 count against the deficit ceiling in that same year.

Franco Bassanini (President of the Cassa Deposity e Prestiti, CDDPP, a public agency managing postal savings, funding infrastructure and public enterprises) and Marcello Messori (Rome LUISS University) worked out for the ASTRID Foundation a clever and simple method for getting rid of all Public Administration payment arrears, both on capital and current account, without infringing expenditure and deficit (and therefore debt) ceilings.

Namely, Public Administrations would be asked to verify, and either challenge or certify within a period of 2-3 months, any claims of payment arrears by commercial suppliers. Certified credits would be guaranteed by the state (guarantees being a contingent quasi-fiscal liability of the state, not accounted for as expenditure) and could therefore be discounted by banks at a small premium (of 1%-2%, and anyway under 2% for the credit to continue to enjoy the state guarantee).  Banks would have an incentive to accept them because they could always use them as collateral with the ECB to obtain liquidity, and moreover would improve the position of Public Administrations towards the banks themselves. Beneficiary enterprises could in turn reduce their liabilities towards suppliers, invest and hire new employees. VAT owed on unpaid arrears and currently suspended would also be paid, providing additional government revenue. J.P. Morgan calculated that in Spain, which was suffering from a similar predicament and paid off about €30 bn of Public Administration commercial debts, GDP grew by 1.2% as a result; in Italy the impact on growth could be greater. (See the interview with Franco Bassanini in La Repubblica, 10 March).

On 18 March 2013 EU Vice-Presidents Antonio Tajani and Olli Rehn had already accepted that “attenuating factors could be applied to the liquidation of commercial arrears” from the view point of the Growth and Stability Pact, but the principle was implemented only partially, thus involving the Ministry of the Economy and Finance in complex intermediation to establish eligibility and priorities, that slowed down the reduction of arrears. And last summer amendments removing state guarantees and establishing undetermined ceilings to arrears reduction stopped payments altogether under Enrico Letta’s government.

In a recent TV programme Franco Bassanini declared that current account arrears (which he put at between €20 bn and €100 bn) could be specifically removed from the “internal” Growth and Stability Pact, having been already included in past deficits, and paid by next June, while capital account arrears (of between €5bn and €10 bn) could be paid by 21 September as announced by the new Premier Matteo Renzi. Public Administrations without the necessary funds could take a 5-year loan guaranteed by the state, which in case of insolvency would be acquired by the CDDPP, on a longer maturity basis of the order of 15 years. More power to his elbow.

Kornai: Shortage versus Surplus Economies

The eminent Hungarian economist Janos Kornai successfully characterized the Soviet-type, centrally planned socialist economy as The Shortage Economy (2 Vols, 1980). Whether money prices were stable, rising or falling, those economies were characterized by large-scale, endemic excess demand at prices below the market-clearing level, with associated re-trading (whenever feasible) at higher black market prices.

 

Kornai attributed shortages primarily to soft budget constraints, i.e. the ability of state enterprises to replenish their liquid resources through budget subsidies or credit (by banks or suppliers) whenever money prices were raised in order to reduce shortages. However, soft budgets can explain open inflation but are neither necessary nor sufficient to explain repressed inflation, which requires simply administered prices consistently lower than market-clearing: socialist planners could not eliminate inflation, so they simply pretended they had, and repressed it.  

But Kornai is certainly right in emphasizing the negative implications of shortages: labour over-full employment was associated with consumers’ frustration at their inability to secure goods and services at official prices, and with production inefficiencies, and vanified any attempt to establish forms of market socialism. 

In his latest book, Dynamism, Rivalry and the Surplus Economy (OUP 2013), Janos Kornai characterizes capitalism on the contrary as the economy of surplus, of excess supply and labour unemployment – not cyclical a’ la Keynes but endemic. 

The novel aspect of this characterization is its positive assessment as an environment favourable to dynamism, entrepreneurship and technical progress, innovation and structural change, while central planning, together with the failure to allow experimentation, reward the successful inventor and innovator, and to make available resources outside a rigid central plan, was ultimately responsible for systemic stagnation. Both systems have merits and drawbacks that Kornai regards as inseparable and genetically implanted in the two systems. His personal preference goes to the surplus economy, although he recognizes the evil of unemployment associated with it.

Kornai supports these provocative propositions with a mass of data on technical inventions and their diffusion in the two systems. Nevertheless, some reservations are in order.

First, the contribution of the state to technical progress is under-estimated by the acknowledged exclusion of military and space expenditure and generally the non-profit sector, without which we would not have had most IT progress including Internet. Conversely, the negative implications of capitalist protection of intellectual property have been overlooked.

Second, is shortage a necessary feature of socialism, i.e. is China a shortage economy?

Finally, the glorification of the surplus economy seems to have been somewhat mis-timed, considering both the large-scale costs of the “transformation recession” (Kornai’s label) of transition economies in the 1990s, and the persistence and severity of the current global crisis that began in 2007 and is still rampaging. Austerity has raised the surplus features of capitalism far beyond what may be regarded as necessary to enhance entrepreneurship and technical dynamism. 

(A session on Kornai' s latest book will be held at WINIR - World Interdisciplinary Network for Institutional Research - Conference on “Institutions that change the World”, Greenwich, London, 11-14 September 2014).

Germany: Too Much Virtue Is A Sin

On 30 October the Office of International Affairs of the US Treasury issued its customary semi-annual Report to Congress on “International Economic and Exchange Rate Policies”, in consultation with the Fed’s Board of Governors and IMF management and staff. The Report usually concentrates on China bashing for the undervaluation of the renmimbi, and this time is no exception: “The RMB is appreciating on a trade-weighted basis [by 6.6% on a real effective basis], but not as fast or by as much as is needed [an additional 5-10%]”. But the Report in addition vigorously criticizes Germany for its record trade surplus, which is regarded as a brake on the recovery of the Eurozone countries that experience a corresponding trade deficit and on global growth.

Among the Report’s Key Findings (p.3):

“Within the euro area, countries with large and persistent surpluses need to take action to boost domestic demand growth and shrink their surpluses. Germany has maintained a large current account surplus throughout the euro area financial crisis, and in 2012, Germany’s nominal current account surplus was larger than that of China. Germany’s anemic pace of domestic demand growth and dependence on exports have hampered rebalancing at a time when many other euro-area countries have been under severe pressure to curb demand and compress imports in order to promote adjustment. The net result has been a deflationary bias for the euro area, as well as for the world economy.”

The main text of the report develops this proposition further: much of the decline in global current account imbalances that occurred in recent years reflects a demand contraction in deficit countries rather than strong domestic demand growth in current account surplus countries. Germany in particular has continued to run a very large and persistent surplus, raising the eurozone's overall current account, which was close to balance in 2009-2011, to a surplus of 2.3 percent of GDP in the first half of 2013. “Germany’s current account surplus rose above 7 percent in the first half of 2013, while the current account surplus for the Netherlands was almost 10 percent. Ireland, Italy, Portugal and Spain are all now running current account surpluses as import demand in those economies has declined. Thus, the burden of adjustment is being disproportionately placed on peripheral European countries, exacerbating extremely high unemployment, especially among youth in these countries, while Europe’s overall adjustment is essentially premised on demand emanating from outside of Europe rather than addressing the shortfalls in demand that exist within Europe.”

The section on the Euroarea emphasises the point: “Expansion was supported by domestic demand growth in Germany - though growth in Germany still continues to rely on positive net exports, which continues to delay the euro area’s external adjustment process – and on domestic demand in France.”

Nobody can argue with such propositions, which are based on a correct interpretation of well established facts, and are not at all new. The adoption by Germany of more expansionary policies has been advocated by many economists, from Martin Wolf (FT) to Paul Krugman (Those Depressing Germans, NYT 3 November 2013), from Jean Pisani-Ferry (Bruegel) to Mario Seminerio (La Cura Letale, Rome, 2012), to the IMF Managing Director Christine Lagarde as well as several IMF documents. What is extraordinary is that the criticism should come from the US government and from research circles before it is raised by the European Commission. 

EC practice suffers from a totally arbitrary and unwarranted asymmetry in treating surpluses and deficit countries: a current account deficit of 4% of GDP triggers off a disciplinary procedure for the offending country, while a 6% surplus averaged over three years is necessary before the EC takes any notice of that imbalance, and even then only perfunctorily. In 2012 Germany recorded a 7% record surplus but the three year average was just under 6% and nothing was said.

This is a general problem that Maynard Keynes had tried to address at the Bretton Woods Conference (1944). His Plan assigned to every country a “bancor” maximum overdraft facility equal to its average trade over five years; a penalty interest rate of 10% would apply to deficit countries above that limit, as well as to surplus countries on anything over and above any surplus exceeding the size of the permitted overdraft by more than a half, forcing compensatory exchange rate adjustments or capital flows, and subject to confiscation of residual excess reserves above the permitted surplus at the end of the year. “Nothing so imaginative and so ambitious had ever been discussed", commented Lionel Robbins. But the US was then the world’s biggest creditor and the Plan by the US representative Harry Webster White was preferred by the 42 countries attending the Conference. The burden of balancing trade was placed on deficit countries and no limit was set on surplus countries, thus necessarily impressing a deflationary bias on the nature of trade adjustments. The replication of this approach by the European Union is one of the many EU original sins. 

There is a well known tenet of Keynesian economics, resulting from national income accounting and not at all dependent on the validity of Keynesian fiscal policies, and therefore unchallenged: the excess of exports X over imports M, plus the excess of government expenditure E over taxation T, plus the excess of private investment I over savings S, must necessarily add up to zero. Thus a country experiencing a trade deficit must necessarily run a government deficit and/or a compensatory excess of investment over savings, hard to accomplish in the face of an otherwise shrinking demand. In other words, the German trade surplus makes it all that much harder for its deficit trade partners to balance their public accounts.

On 2 November the Economist’s Charlemagne column Fawlty Europe commented on “Germany’s obsession with competitiveness”… “For Germany booming exports are the measure of economic virility.” It is true that Germany is reaping the benefits of wage and price reductions (the internal devaluation) undertaken before the crisis; in the middle of the crisis any country adopting the same policy would pay the price of worsening that crisis. Germany also benefits from earlier structural reforms politically hard to replicate, and from the relatively price-inelastic demand for its high technology exports. But surplus countries like Germany, the Netherland and Austria are also benefiting from an artificially low exchange rate, with respect to the increasingly stronger exchange rate that would prevail if those countries were using their own currency instead of the euro. And, be that as it may, by holding down wages and failing to promote investment and growth they make trade adjustment in Italy, Spain, Ireland, Portugal and Greece – which has occurred – deflationary. Debtor nations were forced, mostly under German pressure, into austerity eliminating trade deficits at the cost of perversely rising debt/GDP ratios (see our earlier post on the subject), while German surpluses persisted and their failure to adjust magnified the costs of austerity and contributed to keep the world economy depressed.

Charlemagne notes that Germany has also benefited from straight protectionism, having failed to liberalise its construction and services.  While these sectors are not a significant share of German exports, a recent OECD study stresses that in general services have a much bigger impact on trade and trade competitiveness if we look at their inputs actually embodied in exports, i.e. adopting a Value Added approach to trade accounting. Charlemagne also recommends too that Germany could do more to invest in education and infrastructure, and make child care available for working women. 

Moreover German energy-intensive producers are benefiting from an implicit subsidy on their electricity consumption, through exemption from the expensive surcharge used to finance Energiewende, the accelerated introduction of renewable energy scheduled to reach 35% by 2020 and 80% by 2050. Earlier this year European Energy Commissioner Günther Oettinger told a group of industry leaders that the price concessions for energy-intensive companies in Germany clearly amount to “inadmissible” subsidy levels. German business are concerned that they might have to repay hundreds of millions of euros to the German government.

Only on 13 November did Jose’ Manuel Barroso, the EU President, announce an “in depth analysis on the high German trade surplus”, with a view to understand whether Germany can make a larger contribution to the re-balancing of the European economy”. There is the prospect of a continued trade surplus of 7% in 2013, and the upwards revision of the 2012 trade surplus brings already the three year average above 6% in 2010-2012. Indeed “Following statistical revisions, the indicator has exceeded the threshold each year since 2007” and “the surplus is expected to remain above the indicative threshold over the forecast horizon, thus suggesting that it is not a short lived cyclical phenomenon” (EC 2013). German savings exceed investment, and despite boasting the second lowest share of private sector debt in GDP (firms and households) and low interest rates, private sector de-leveraging has continued, failing to boost demand; capital formation has declined last year. This calls for some action, not least to reduce the pressure for euro revaluation. But the bottom line of the EC document is simply that “Overall, the Commission finds it useful to conduct an in-depth analysis with a view to assessing whether imbalances exist” (italics in the original). This is a grotesque existential problem: what additional evidence is needed to establish that an imbalance exists, other than the imbalance itself?

German press and politicians have reacted to the US Treasury accusations and to the EC initiative with a combination of denials, hubris and cries of victimisation. The German Economics Ministry issued a strongly worded statement, saying that Germany's surplus is "a sign of the competitiveness of the German economy and global demand for quality products from Germany." It dismissed the accusations as “incomprehensible” and challenged the US to "analyze its own economic situation."

A memo to finance minister Schäuble reads: "The German current account surplus offers no reason for concern for Germany, the euro zone or the world economy"; Berlin is pursuing a course of "growth-friendly consolidation," and there are no imbalances "that would require a correction of our economic and fiscal policy." See also “Complaints about German Exports Unfounded”, by Jung-Reiermann-Schmitz,Spiegel.de 5 November, and “Raw Nerve: Germany Seethes at US Economic Criticism” by Alessi, Spiegel.de 31 October.

It has been pointed out that the prospective new grand coalition between the CDU, its Bavarian sister party, the Christian Social Union (CSU), and the Social Democratic Party (SPD) has already agreed to increase government investment and the minimum wage, both of which should stimulate domestic demand.  But the formation of that government – let alone its programme – is still under negotiation.

The real issue is an EU governance deficit. The worst thing that could happen to Germany as a result of an adverse “in depth analysis” by the Commission is a reprimand by Marco Buti's Directorate-General for Economic and Financial Affairs. No comment seems necessary.

Winter chill in Hungary

Note: This is a guest post contributed by Yudit Kiss, a Hungarian economist based in Geneva, author of several academic publications dealing with the post-Cold War economic transformations of Central Europe. Her articles of wider interest have been published by the Guardian, Lettre International, El Nacional, Nexos, Gazeta Wyborcza & Eurozine.

The only electoral promise Fidesz has fulfilled has been the “restoration of order”, through a myriad of laws, decrees and regulations, a particularly harsh new Penal Code and several new organizations.

On October 23, Hungary commemorated the anniversary of the 1956 revolution, but few Hungarians had cause to celebrate except the ruling Fidesz party, which is eagerly looking forward to next spring’s parliamentary elections.

Fidesz has learned the lessons of its previous spell in power, when in 2002 general disenchantment with its performance lost it the elections. Back in power since 2010, all measures have been taken to avoid a similar defeat. The Fidesz–led government granted voting rights to Hungarian minorities living abroad, changed the election system, redesigned electoral districts, eliminated checks and balances built over the past two decades, reshaped the juridical system and has gained nearly full control over the media and all state institutions.

In addition to a tax system that favours the rich, economic assets from land to productive capacities and infrastructure have been re-distributed to create a new class of loyal, privileged crony capitalists (and large and growing numbers of the poor and very poor). By extending state control over key companies, expropriating the private pension funds and recently, the Savings Cooperatives, by channeling EU money and using the economy’s remaining reserves, the government is able to lavishly finance its own projects and distribute money to its clients through public procurement policies. A recent Transparency International report describes a “state captured by private interest groups”.[i]The government can also finance large-scale publicity campaigns to convince citizens that it acts relentlessly on their behalf, from “defending the country’s independence” to artificial lowering of utility charges.

The economy is at a standstill, with the bulk of investments financed from EU funds. Unemployment is officially close to 10%. Half of those without work are long-term unemployed, and joblessness among youth is nearly 30%. The government’s “solution” to a stagnating labour market has been an expensive and inefficient “public work” system in which job-seekers are employed by (predominantly Fidesz-led) local authorities and compelled to accept whatever work is offered them, often in primitive conditions at less than the official minimum wage.

In September the Statistical Office reported that 3.2 million persons, nearly 33% of the population, live in poverty, including half a million in deep poverty and deprivation.[ii] The drastic reduction of unemployment assistance, welfare benefits and social services, coupled with punitive measures against the poor, homeless and marginalized make their situation desperate. 70% of the country’s approximately 700,000 Gypsies, who under the former system at least had work but have now been brutally expelled from the labour market, live in abject poverty.[iii]

The only electoral promise Fidesz has fulfilled has been the “restoration of order”, through a myriad of laws, decrees and regulations, a particularly harsh new Penal Code and several new organizations, like well-equipped special anti-terrorist units, fancily dressed Parliamentary Guards to discipline MPs, special bodies to supervise public workers and even a school police force with rights to control and search school-age kids.

Through a complex system of regulations, economic pressure, intimidation, propaganda and hand-outs the government has extended its control over its citizens’ life from the cradle to the grave, from economics through the education system to artistic creation, including the private sphere, with measures that spread from encouraging marriage and child birth to the reform of state funeral services, going as far as authorizing itself to spy on state employees and their families.

Each of these measures has chilling details that reveal the nature of the system. Teachers, whose work conditions have significantly worsened, have to join a government-created ‘National Teachers’ Body’ and are expected to sign an ‘Ethical Code’ created by it; youngsters can risk two years of prison if they share a joint at a school party; the poor are offered a “social burial” - an (initially) free site in a separated section of the cemeteries, with uniform graves fabricated by prisoners - provided they bury their dead themselves.

Protest, dissent and criticism are actively discouraged, neglected or dealt with by one of Fidesz’ basic methods of governing: ‘divide et impera’. The government’s outspoken critics come under virulent, orchestrated attacks. Criticism abroad – including from the EU institutions in Brussels - is dismissed as “unfounded” or ‘fuelled by international capital and business’ or by the internal opposition that “betrays” the fatherland. And if all this were not enough to secure a next mandate, the government has less elegant methods. In a recent municipal election in Baja, Roma families were paid and driven to the ballot box to cast their vote for Fidesz. (Some over-zealous opposition activists forged a video to “prove” the fraud - when they were caught, Fidesz was able to turn the whole affair to its advantage.)

Nevertheless, Fidesz probably wouldn’t need to use its heavy weaponry, since its opposition is pathetically weak and divided. The ‘Együtt 2014’ (Together 2014) electoral platform that evoked high hopes when it was founded a year ago has failed to come out with a convincing alternative vision for the country. But even if the opposition miraculously pulls itself together to win next Spring’s elections, the new government’s hands would be tied by Fidesz legislation and Fidesz appointees who occupy all key state positions, from the juridical system to media supervision, with long mandates stretching over election cycles. The case of Esztergom, where since 2010 the Fidesz-dominated city government has paralyzed the whole city to obstruct an independent mayor, is a sinister foreboding.

According to recent polls[iv], the large majority of the population believes that things are bad and will deteriorate further in Hungary. However, 42% of potential voters don’t know who to vote for and probably won’t participate in the next elections. Absenteeism mixed with massive disappointment in mainstream political forces is a dangerous cocktail, like the advance of the far right in Europe shows. Jobbik, the Hungarian party of the extreme right, is looking confidently forward to next Spring, like Fidesz. At present 26% of potential voters would vote for Fidesz - enough for them to win the elections and have again an overwhelming majority in Parliament, thanks to the electoral system they’ve installed.

This year’s commemoration of the 1956 revolution and its aftermath played out the worst-case scenario for the coming election year. Prime Minister Victor Orban used the national holiday as his Party’s first electoral rally, greeting the “spontaneous” masses of the “Peace March” (organized and sponsored by loyal Fidesz supporters) from a platform decorated with a sea of national flags and surrounded with armed soldiers. His speech was a violent call for battle against the country’s external (‘colonizers, speculators and international financiers’) and internal enemies (former, present and would-be “Communists”, including their “comrade”, ‘tavarish’ Tavares) ‘who sold the country’ and ‘would shoot at us today …if they could’. [v]

In front of the building of the Technical University, where the first student rally that set in motion the mass protest movement in October 1956 started, a large crowd of opposition supporters gathered hoping to revive hope in a free and democratic country – the real message of 1956. Instead of the so much needed demonstration of unity, the event turned into a disheartening manifestation of division and in-fights in the ranks of the various opposition formations that has been going on since. The day after the national holiday, a government official and media close to Fidesz launched yet another attack against the philosopher Agnes Heller, who dared to criticize the government in an interview with Swedish television.

A couple of days later a government-backed march was held all over the country to demand autonomy for Sekler’s Land (a part of Transylvania with a large Hungarian population that belonged to pre-WW1 Hungary) organized by a civil society organization and some of the Peace March organizers. By the end of the week, a bronze statue of Admiral Miklós Horthy[vi], a former ally of Hitler, the leader of Hungary between 1920 and 1944, was unveiled at the entry of a Reformed Church located in the centre of Budapest, by the Church Minister, well-known for his extreme-right views and by the same Jobbik MP who some months ago demanded the listing of Jewish members of Parliament. In his first reaction, the Fidesz mayor of the district only managed to regret the fact that this provocation might fuel further ”anti-Hungarian” criticism in western “leftist” media. 

This is a rather pernicious preview of a possible future for the country. Hopefully it will serve as a wake-up call for those who want to live in a different Hungary.

---

[i] http://www.transparency.hu/National_integrtity_study

[ii] http://www.ksh.hu/docs/hun/xftp/idoszaki/laekindikator/laekindikator12.pdf

[iii] http://www.romadecade.org/cms/upload/file/9270_file9_hu_civil-society-monitoring-report_hu.pdf; http
[iv] http://hvg.hu/itthon/20131017_Ipsos_nott_az_ellenzek_tabora  & http://median.hu/object.aa1da5a0-e054-4ffb-8e6f-784e318108e1.ivy
[v] http://www.kormany.hu/hu/miniszterelnokseg/miniszterelnok/beszedek-publikaciok-interjuk/a-nagysag-dicsoseget-hagytak-orokul-1956-hosei
[vi] http://hungarianspectrum.wordpress.com/2013/11/05/political-controversy-over-the-role-of-regent-miklos-horthy-1920-1944/

Perverse Fiscal Consolidation

Between 2011-2013 IMF documents and research papers have revised upwards earlier estimates of fiscal multipliers, which throughout 1970-2009 were assumed by the IMF and other international organisations to be on average about 0.5 for advanced countries (Blanchard and Leigh 2012, 2013, Batini et al. 2012, Cottarelli and Jaramillo 2012 and other researchers associated with the IMF).

The upward revision applies from 2010 and was justified by: the ineffectiveness of countervailing monetary expansion close to the zero floor of the interest rate, lack of opportunities for exchange rate devaluation especially in the Euroarea, by a large gap between potential and actual income (for fiscal multipliers are higher in a downturn than in a boom); and by simultaneous recent consolidation across countries.  Moreover, the fiscal multiplier for expenditure cuts – contrary to earlier claims - turns out to be much (up to ten times) higher than for tax rises.

This means that fiscal consolidation is more expensive in terms of output loss than previously believed.  But there is worse: the higher are fiscal multipliers, the higher is the probability that fiscal consolidation will have the perverse effect of actually raising the Public Debt/GDP ratio. 

Namely:  a fiscal consolidation (tax increases plus government expenditure cuts) will always necessarily result in an increase instead of a decrease of the Public Debt/GDP ratio, with respect to what that ratio would have been in the absence of fiscal consolidation, as long as the fiscal multiplier – or more precisely the weighted average of fiscal multipliers applicable to the composition of the fiscal package – is greater than the inverse of the country’s Public Debt/GDP ratio. Thus in such circumstances fiscal consolidation, contrary to received wisdom, will make Public Debt more rather than less costly to re-finance, and therefore less instead of more sustainable. In plain words, fiscal consolidation works only in those countries that, having a sufficiently low Public Debt/ratio, do not actually need a consolidation.

Here is the proof. Given D=Public Debt, Y=GDP, d=D/Y, x=the size of fiscal consolidation (tax rises plus expenditure cuts of given composition) expressed as a share of GDP, 

ΔD=-xY

ΔY= -mxY

where m is the appropriate fiscal multiplier,

Δ(D/Y) = [(ΔD)Y – (ΔY)D]/Y² = 

= [(-xY)Y – (-mxY)D]/Y²

= -x Y²/Y² + mxY D/Y² =

= -x + mxD/Y = mxd – x  and therefore                 

Δ(D/Y) = x(md – 1) = xd(m – 1/d)

from which we can see that the ratio D/Y must increase,
i.e. Δ(D/Y) >0,  if and only if m>1/d.  Q.E.D.

The interest of this proposition is in the fact that the inverse of the D/Y ratio is naturally all the smaller the more heavily indebted a country is, and particularly small with respect to the kind of fiscal multipliers estimates that have been produced in recent literature (such as Blanchard and Leigh 2012, 2013, Batini et al. 2012, Cottarelli and Jaramillo 2012 and other researchers associated with the IMF). Thus the counterproductive nature of fiscal consolidation in advanced economies, especially in highly indebted countries with high fiscal multipliers, is an absolute certainty.   

Figure 1. Illustration of perverse fiscal consolidation raising the Public Debt/GDP ratio (CLICK TO ENLARGE): Δ(D/Y) >0 for plausible values of m and as an increasing function of D/Y. 

The figure above (for which I am indebted to my colleague Marilena Giannetti) illustrates the impact of a fiscal stabilisation package of 5% of GDP, relatively modest by the standards of the current crisis, on the Public Debt/GDP ratio, Δ(D/Y)= x(md – 1), as a function of the current d=D/Y ranging from 50% to over 200% of GDP and for alternative values of fiscal multipliers ranging from 0.5 to 3.5.  At high D/Y ratios and relatively high multipliers still within the range estimated by recent IMF sources, the rise in D/Y can be devastating. 

By way of example, a country with d=1.20, m=3, undertaking a stabilisation of x=5%, would raise its d by 0.05*(1.20*3-1)=13% of GDP, from 1.20 to 1.33.  In a country like Japan, for a Public Debt at over 200% of GDP, a fiscal consolidation package of 5% would lead to an increase of the Public Debt/GDP ratio of the order of 30% of GDP. For a perverse effect of fiscal consolidation on such a massive scale the claim that “The short-term effects of fiscal policy on economic activity are only one of the many factors that need to be considered in determining the appropriate pace of fiscal consolidation for any single economy” (Blanchard and Leigh, 2013, p.6) is facile and disingenuous. Such a regime switch cannot be ignored.

Table 1. Threshold of the fiscal multiplier over which fiscal consolidation necessarily leads to higher Public Debt/GDP ratio for selected countries (calculated as the GDP/Public Debt ratio, from the data estimated by US-CIA, The World Factbook, 2013, for 2012), ranked by increasing value of the multiplier threshold.

Country    Public Debt/GDP      GDP/Public Debt

Japan            214.3                        0.47
Greece          161.3                        0.62
Ireland          118.0                        0.84
Italy              126.1                        0.79
France             89.9                        1.11
UK                  88.7                        1.13
Spain              85.3                        1.17
Germany         81.7                        1.22
Hungary          78.6                        1.27
Austria            74.6                        1.34
US                  73.6                        1.36
Netherland       68.7                       1.45
World  average 64.0                       1.56
Albania            60.6                       1.65
Poland             53.8                       1.85
Finland            53.5                       1.87
Slovakia          48.6                       2.06
Czechoslovakia 43.9                       2.21
Denmark         45.3                        2.21
Sweden           38.6                        2.56
Romania          37.2                        2.69

We have seen above that before the crisis the value of fiscal multipliers generally assumed by the IMF for advanced economies for forty years (1970-2009) was on average 0.5.

This leads to the presumption that – if national fiscal multipliers were all identical to the group average of 0.5 – only in Japan (with a GDP/Public Debt ratio as low as 0.47 in 2012 and 0.43 in 2013) would fiscal consolidation have raised the Public Debt/GDP ratio, and only very marginally at that. In all other countries fiscal consolidation would have worked, lowering both D and the D/Y ratio. 

The lower bound of the fiscal multipliers revised by Blanchard and Leigh (2012 and 2013), at 0.9, would imply a perverse consolidation pattern in 2012 not only in Japan but also in Greece, Ireland and Italy; while the upper bound of 1.7 would add to the list of perverse consolidation also France, the UK, Spain, Germany, Hungary, Austria, the US, the Netherlands and Albania.

The lower bound of the expenditure multipliers estimated by Batini et al. (2012), 1.6, would remove only Albania from the list of perverse fiscal consolidation, but its higher bound 2.6 would include – in addition to the previous list, also Poland, Finland, Slovakia, the Czech Republic, Denmark and Sweden, leaving out Romania as the only country in table 1 in which consolidation would not raise the Public Debt/GDP ratio and reduce GDP growth.  Using the range of estimated multipliers for tax rises, 0.16-0.35, on the contrary, that kind of fiscal consolidation would always work, i.e. would reduce both the absolute level of Public Debt and its ratio to GDP.

For the multiplier estimated by Auerbach-Gorodnichenko (2012b), near zero in normal times to about 2.5 during recessions, fiscal consolidation would work always in a boom, and never in a recession except in Sweden and Romania.  Finally, for Christiano et al. (2011), with the multiplier at 3.2 once the interest rate approaches the zero interest lower bound, all the countries in Table 1 would experience perverse fiscal consolidation. 

It is reasonable to presume that all the IMF researchers involved in this kind of work must have been aware of such devastating implications of the upward revision of fiscal multipliers.  My colleague and good friend Giancarlo Gandolfo helped me to work out the proof of the proposition above linking the multiplier to the inverse of the Public Debt/GDP ratio, for which I am most grateful, but in all honesty he would be the first to point out that the proof does not involve the use of rocket science.  Cottarelli and Jaramillo (2012) who discuss the feedback loops between fiscal policy and growth, get remarkably close to that proposition, but use an obscure turn of phrase, and stop short of stating it in so many words, or mathematically:

“a deceleration of growth prompted by a fiscal consolidation could result in a rise in the government debt-to-GDP ratio. This is found to be the case if the initial stock of debt is large and the fiscal multiplier is high. The effect of fiscal tightening on debt (the numerator of the ratio) in percentage terms is smaller the higher the initial stock of debt to GDP. Meanwhile, the negative effect of fiscal tightening on GDP (the denominator of the ratio) is larger the higher the fiscal multiplier.”

The point is that although the participants in the debate "should not be reported as representing the views of the IMF", as stated in all IMF publications, naturally their writings are taken as a pointer to the way IMF views are evolving.  Therefore they must be anxious not to suggest that their upwards revision might result in perverse fiscal consolidations in all or near all advanced economies, and baulk at saying in so many words that fiscal consolidation backfires precisely in those highly indebted countries on which it is pressed most energetically. Thus Blanchard and Leigh (2013) are adamant:

“... our results should not be construed as arguing for any specific fiscal policy stance in any specific country. In particular, the results do not imply that fiscal consolidation is undesirable.”

And Cottarelli and Jaramillo (2012) make a case against abrupt, front-loaded and simultaneous fiscal consolidations (like Blanchard and Cottarelli had done separately in 2011 and 2012 respectively).  “It is imperative to lower Public Debt over time”, though:  “However, in the short-run, front-loaded fiscal adjustment is likely to hurt growth prospects, which would delay improvements in fiscal indicators, including deficits, debt, and financing costs. A measured, although not trivial, pace of adjustment, based on a clear medium-term plan, is therefore preferable, if market conditions allow it.” Nevertheless, they claim that fiscal consolidation and economic growth go “hand in hand”.

All researchers advocate structural reforms, precisely to offset the recognition that fiscal adjustment will slow down growth.  “Reforms in goods, services, and labor markets that improve economic efficiency will boost potential growth, in turn serving as important tools in the fiscal adjustment process” (Cottarelli and Jaramillo 2012). These cover a multitude of sins and virtues that have mixed and ambiguous effects, if any, and in any case only in a distant long-run.    The notion of a virtuous circle in which “pro-growth fiscal adjustment measures, other structural reforms, and lower debt boost growth and the latter facilitates fiscal adjustment” (ibidem) is pie in the sky, and a dangerous vision if it is used to justify perverse fiscal consolidation.

The proposition that fiscal consolidation harms development only when it is abrupt, front-loaded and internationally coordinated is a non-sequitur.

At this point two further considerations are in order.  First, we know – not least from Cottarelli and Jaramillo (2012, Appendix on Short-run Determinants of CDS Spreads in Advanced Economies) – that a country’s cost of borrowing tends to rise with the Debt/GDP ratio and with the fall in the growth rate, both phenomena being associated with “perverse” fiscal consolidation i.e. with the near totality of consolidations.  For “a deceleration of growth prompted by a fiscal consolidation could trigger nervousness in financial markets” and “...markets seem to have been focusing recently on short-term growth developments.”  “The possible increase in spreads when fiscal policy is tightened creates a problem for upholding a fiscal adjustment strategy, not only because higher financing costs increase the overall deficit, but also because of political economy reasons. If painful fiscal tightening is accompanied by early evidence of an improvement in credibility, the adjustment is more easily sustained, but if markets do not reward the effort, the resolve of the government to carry on the fiscal adjustment may be undermined.”  Therefore fiscal consolidation can and often does generate a vicious circle that makes Public Debt more and more unsustainable. 

Second, we know that in a prolonged depression productive capacity does not just stand idle but is actually destroyed: factories close down with no more than a fraction of their productive capital being re-deployed elsewhere, if at all, in other productive uses; human capital is also destroyed, as workers made redundant are dispersed, and their skills are lost or forgotten or made obsolete.  When actual output falls below potential output, at some point gross investment stops and net investment falls below zero as unused or obsolete capital is not replaced, thus reducing not only employment but the number of those “employable”, pulling down the growth path of potential output (Vianello 2005). “An insufficient demand protracted over time unavoidably generates a slowdown in the formation of new productive capacity and therefore of potential income” (ibidem). Discouraged workers will stop looking for work and the rate of participation will fall.  As Nicholas Kaldor (1983) had argued, “It is illegitimate to assume that there exists a long run equilibrium growth path, for a single country or even the world as a whole, determined by population growth, capital accumulation and the rate of technical progress, all taken exogenously [italics added].” (p. 95).

In such conditions, in the world as we know it, fiscal consolidation definitely can harm economic growth and development, even if it is not abrupt, front-loaded and internationally coordinated.  This is not to say that there are no limits to a country’s or even a group of countries’ ability to sustain a fiscal stimulus.  But fiscal consolidation has to be avoided absolutely as long as the GDP/Debt ratio is smaller than the fiscal multiplier – even if otherwise the country is growing less fast than the interest rate on its debt, for with perverse fiscal consolidation the country would continue to raise its Debt/GDP ratio even faster than with continued fiscal stimulus. 

This is true even if government expenditure consists of Keynes’ proverbial policy of hiring some workers digging holes and others filling them, that Tanzi (2012) would relegate “to the museum of old and wrong ideas” (p. 11).  Obviously the replacement of unproductive expenditure with productive investment has significant additional benefits over a continuation of unproductive investment such as digging and filling holes or building pyramids or cathedrals, but even the continuation of such unproductive investment is superior to fiscal consolidation.  

REFERENCES

Auerbach Alan, and Yuriy Gorodnichenko (2012a), “Fiscal Multipliers in Recession and Expansion,” in Alberto Alesina and Francesco Giavazzi, Fiscal Policy after the Financial Crisis, University of Chicago Press.

Auerbach Alan, and Yuriy Gorodnichenko (2012b), “Measuring the Output Responses to Fiscal Policy,” American Economic Journal – Economic Policy, Vol. 4, pp. 1–27. 

Auerbach Alan, and Yuriy Gorodnichenko (2012c), “Output Spillovers from Fiscal Policy,” NBER Working Paper No. 18578, Cambridge, Mass. 

Batini Nicoletta, Giovanni Callegari and Giovanni Melina (2012), “Successful Austerity in the United States, Europe and Japan”, IMF Working Paper 12/190, July, Washington.

Blanchard Olivier J. (2011), “Blanchard on 2011’s four hard truths”, 23 December,  http://www.voxeu.org/article/blanchard-2011-s-four-hard-truths 

Blanchard Olivier J. and Daniel Leigh (2012), “Box 1.1. Are We Underestimating Short-Term Fiscal Multipliers?” in International Monetary Fund (2012), World Economic Outlook - Coping with High Debt and Sluggish Growth, Chapter, “Global prospects and policies”, pp. 41-43., October, Washington.

Blanchard, Olivier J. and Daniel Leigh (2013), Growth Forecast Errors and Fiscal Multipliers, IMF Working Paper No. 13/1, January, http://www.imf.org/external/pubs/ft/wp/2013/wp1301.pdf 

Christiano Lawrence, Martin Eichenbaum, and Sergio Rebelo (2011), “When Is the Government Spending Multiplier Large?”, Journal of Political Economy, Vol. 119, pp. 78–121. 

Cottarelli Carlo (2012), “Fiscal Adjustment: Too Much of a Good Thing?”, Posted on January 29 by iMFdirect. 

Cottarelli Carlo and Laura Jaramillo (2012), “Walking Hand in Hand: Fiscal Policy and Growth in Advanced Economies”, IMF Working Paper WP12/137 http://www.imf.org/external/pubs/ft/wp/2012/wp12137.pdf

International Monetary Fund, (2010), World Economic Outlook: Recovery, Risk, and Rebalancing, October, Washington 

Kaldor Nicholas (1983), “The role of effective demand in the short run and the long run”, reprinted in Targetti Ferdinando and A. P. Thirlwall, Eds., (1989) Further essays on economic theory and policy – Collected economic essays, vol. 9, Duckworth, London. 

Tanzi Vito (2012), Realistic Recovery - Why Keynesian Solutions Will Not Work, http://www.politeia.co.uk/sites/default/files/files/Vito%20Tanzi%20Final.pdf London, Politeia.

Vianello Fernando (2005), “La Moneta Unica Europea”, mimeo, and in Economia & Lavoro (2013), XLVII-1, pp. 27-46.