An austere 2012

di Luca Macedoni

We are getting used to a constant flow of depressing macroeconomic data. On January the 31st Eurostat released the latest news on unemployment: in December 2011 10.4% of the working population in the Euro Area was looking for a job. This value, that is the highest since 1999, is even worse for young workers: the youth unemployment in the Euro Area is 21.3%, with an Italian peak of 31[1].

Just a week earlier, the January update of the IMF World Economic Outlook[2] forecast a stagnant year for European economies, with recessions in Italy and Spain (-2.2% and -1.7%, relative to 2011) and stagnant Germany and France (0.6% and 0.5%). These latest data confirmed a downward trend on European growth expectations: while in April 2011 expected 2012 GDP growth in the Euro Area was +1.8%, each subsequent update of the World Economic Outlook was worse, till the last update: 2012 Euro Area’s GDP will decrease by 0.1%.

Was that a surprise? Not really. Plunging gross domestic products are the result of the austerity measures that European Governments were planning and approving during 2011 (as we predicted in August[3]). The more governments reduced their purchases, the lower the 2012 GDP. The lessons taken from 1929 and, more recently, the Japanese lost decade, were simply ignored.

Figure 1. Unemployment in the Euro Area. (monthly data, seasonally adjusted)

Source: Eurostat

This crisis was no different. It is the same old story of deleveraging private agents, that in order to repay their debts, stop consuming and investing (see the McKinsey report on deleveraging for further data[4]). When consumption and investment fall, namely when private households, entrepreneurs and financial institutions increase their savings, there is not enough demand to sustain full employment.

When the housing bubble burst, many financial assets held by banks were virtually worthless. Thus, banks started saving, to clean up their balance sheets. Credit was crunched: money was used by banks to repay their debts, so that firms were denied access to capital. Investments plunged (fig 2). At the same time consumers, already highly mortgaged, started doing the same as well. Decreasing investments and consumption brought aggregate demand down.

Figure 2. Gross fixed capital formation (2007Q4=100)

Source: Eurostat

Facing a declining demand, firms began to lay off their workers. Unemployment then increased, further reducing aggregate demand. Through world trade and financial markets, the crisis spread even to countries without a housing bubble. Everything is made worse off by deflation, which increases the real burden of debt. If prices are declining due to a falling demand, firms revenues are also reduced. But since their nominal debt has not changed, it will take more time to repay that debt. And an already deleveraging agent starts saving even more, thus fostering the debt-deflation spiral.
This was a brief description of what has affected advanced economies since 2007. And it would keep on as long as private agents need to deleverage.
Who is going to reverse this trend? Only governments could, increasing their debts and stimulating demand. It may sound paradoxical, but to solve a crisis generated by private debt, we need more public debt. When everybody in the economy is saving, governments committed to preserving employment should spend and run deficits to sustain the aggregate demand.
This recipe was actually followed until October 2009, when the first rating agency downgraded the Greek sovereign debt. The private debt crisis suddenly became a public debt crisis and the new recipe was austerity, not fiscal stimulus. The underlying philosophy is that governments should behave as private indebted agents: when their debt is too high they should deleverage. As a result, European governments began to save, decreasing public spending and increasing taxes. Using Trichet’s words in June 2010, “As regards the economy, the idea that austerity measures could trigger stagnation is incorrect […]. Everything that helps to increase the confidence of households, firms and investors in the sustainability of public finances is good for the consolidation of growth and job creation.”[5]
Despite deficit hawks and their theories, decreasing public deficits additionally dwindles the aggregate demand. The eventual result is not confidence, but a stop of the European economic growth.
Austerity emerged as a recipe because of a wrong diagnosis. The problem was not the Greek debt in and of itself: the problem was the lack of fiscal union in Europe, namely the absence of a common economic government that could stop every possible speculative attack.
Are there reasons to hope for a better-than-expected 2012? Only on the European side. The December 2011 Bruxelles meeting, in fact, started the process toward a fiscal union, which is continuing with the new January 2012 meeting. A process that has been long and still not completely shared. It seems that, despite the reluctance of the “virtuous” countries, the attack on the sovereign debt of European countries might come to an end, earlier than one could have imagined in October or even November.
However, this is the only reason to hope. The paradigm of austerity is still one of the founding features of the new fiscal union. Hence, there are no good reasons to forecast a greater GDP in 2012, unless the new austerity rules decided in Bruxelles meeting were just a way to give to the European Union only the responsibility for expansionary fiscal policy.

[1] Eurostat news release, January 2012. Euro area unemployment rate at 10.4%.
[2] IMF, January 2012. World Economic Outlook update.
[3] Fabio Sdogati, August 2011. Riflessioni sulla crisi 2007-20??.
[4] McKinsey & Company, July 2011. Debt and deleveraging: The global credit bubble and its economic consequences (Updated analysis).
[5] Interview with Jean-Claude Trichet, President of the ECB, and La Repubblica, June 2010.

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