07.09.2013 0

Credit contraction, not austerity, cause of euro woes

By Robert Romano

Call it the Keynesian fallacy — an absurd hubris of politicians and pundits — who assume that government spending, because it is included in the measure of the Gross Domestic Product (GDP), is somehow a meaningful indicator of national economic well being.

In Jan. 2012, New York Times columnist and economist Paul Krugman declared “a failure, in particular, of the austerity doctrine that has dominated elite policy discussion both in Europe and, to a large extent, in the United States for the past two years.”

It becomes then an article of faith that fiscal policy is a useful tool to utilize when downturns are experienced to “stimulate” the economy. If accurate, rising spending levels should be associated with faster growth rates and lower unemployment. Spending cuts should do the opposite.

For primary evidence many have looked toward Europe in recent years, where it is well known that countries like Greece, Portugal, and Ireland have all undergone significant spending cuts while each economy has struggled and unemployment has been very high. This could be extremely misleading, however.

Lesser known is that in Italy in 2012, spending actually rose by €5.5 billion to €792.5 billion, a small increase 0.7 percent. Yet, the GDP there contracted by 2.4 percent. The same thing happened in Spain, where despite spending increasing €13.5 billion to €493.6 billion, a 2.8 percent rise, the economy shrank 1.4 percent in 2012.

Similarly, in both Spain and Italy, unemployment also rose throughout 2012 to 26 percent and 12 percent, respectively, even with rising spending levels.

Overall, spending in the euro area rose €76 billion even as the economy shrank 0.4 percent and unemployment rose to 12 percent. So, perhaps something else is at play in Europe.

What, then can one make of recessionary conditions seen throughout Europe and rising unemployment regardless if countries are increasing or decreasing spending? In “Reassessing the impact of finance on growth,” Stepehen Cecchetti and Enisse Kharroubi found that “at low levels, a larger financial system goes hand in hand with higher productivity growth. But there comes a point — one that many advanced economies passed long ago — where more banking and more credit are associated with lower growth.”

Ultimately, this leads to downturns and higher unemployment when the bubble pops.

Sure enough, in all of the problem countries Portugal, Italy, Ireland, Greece, Spain, and Cyprus, credit outstanding — that is, all debts public and private — is contracting and has been for months and in some cases years. This is a continent wide episode of deleveraging as individuals, corporations, and banks repair their balance sheets through widespread defaults and through repayment.

As seen in case after case, according to data compiled by Eurostat, when credit is expanding quickly, unemployment tends to be falling or stable. And when either the rate of credit expansion slows down, or it contracts, unemployment rises in some cases rapidly.

If the case of Ireland is any indication, the level of credit contraction needed before unemployment levels will begin to fall back down is incredibly high. So far, public and private debt has fallen €724 billion to €1.093 trillion since 2008 — almost a 40 percent drop and still falling.

There, like in the U.S., the government guaranteed the banking system against losses when its housing bubble popped, preventing a sudden default throughout the financial sector there. The cost of doing so, however, may have been a more prolonged depression as credit markets still have not found their bottom.

Overall, in the Eurozone since January, credit has shrunk by €580 billion, compared with a €212 billion contraction for all of 2012.

Pretty much the same inverse relationship is observed across the entire area as in the individual cases. Credit expansion in the mid-2000s led to a drop in unemployment, and subsequent contractions have led to sharp rises in joblessness.

Ominously, in recent months, even Germany’s credit sector has begun contracting, shedding €170.8 billion this year after almost four years of expansion, although unemployment has not yet ticked upward.

All of which might foreshadow that the recession will continue to worsen in Europe in 2013. It also appears to indicate that the primary problem economically is not seen in fiscal policy per se, but in the financial sector, where credit is contracting, particularly in the private sector.

The only government sector credit event seen so far was in Greece, which defaulted on €100 billion in 2012. That alone cannot explain the overall downward trajectory of credit throughout the Eurozone. Meaning, so long as deleveraging continues — even if fiscal policymakers boost spending — more bumps in the road should be expected.

Robert Romano is the Senior Editor of Americans for Limited Government. 

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