Those familiar with the arcana of classical mythology will recall the case of Cassandra, a prophetess doomed to be forever right and forever ignored. Failed pundits, looking for an upmarket way of saying I told you so, have gone for the title ever since. But most failed pundits stay failed.
The title is an easier fit with a couple of increasingly prominent American academic economists. The first is Nouriel Roubini, a professor of economics at New York University and formerly known as Dr Doom. Economists give speeches all the time but one of Roubini’s was special. On 7 September 2006, when the global boom was still booming and investors still believed in the now-lamented minerals super-cycle, Roubini got on the intercity shuttle and talked to an audience at the International Monetary Fund in Washington. He had a message they did not want to hear.
The American housing market, he predicted, would turn from boom to savage bust. As more and more people found they owed more on their mortgages than the houses were worth, many would stop paying. Trillions of dollars’ worth of mortgage-backed financial products would fail, leading to a global financial crisis that would destroy hedge funds, investment banks and giant mortgage providers. The worst recession in decades would follow. He gave it eighteen months.
Roubini was, of course, right: but that didn’t help him at the time. Journalists and commentators round the world ridiculed him. Australian financial reporters, as is their practice, followed the pack. Whenever they wrote about him, it was with the label Dr Doom. Big joke.
You don’t hear that tag now. None of those witty financial jokesters can seem to remember what they so confidently said back then, just before the crash.
Cassandra status is not always welcomed by those upon whom circumstances confer it. One such is Paul Krugman, a professor at Princeton and one of the most prominent of the world’s quickly growing band of neo-Keynesians. “I’m kind of sick of being Cassandra,” he said. “I’d like to actually win for once, instead of being vindicated by the disaster coming as predicted. I’d like to see my arguments about preventing the disaster taken into account instead.”
He has not been quite so devastatingly right as Roubini was about the Global Crisis Mark 1 but he has a good record. He and others predicted that the Obama administration’s stimulus effort in 2009 was far too small to and poorly designed to rescue the economy and would, instead, merely serve to discredit the whole notion of government-funded stimulus in America and around the world. That was a problem for Krugman and the neo-Keynesians, who see stimulus and growth, rather than austerity and deflation, as the only way out of the world’s financial mess. It’s a problem for the world, too, because they’re probably right. And it’s a problem for President Obama, whose re-election prospects are hugely blighted by his inability to get the nation’s economy moving again.
Krugman pocketed the Nobel Prize for Economics in 2008 for work on international trade and the geographic concentration of wealth. He is also well known for his research on liquidity traps, which happen when injections of cash into a troubled economy fail to provide growth because the new cash is hoarded rather than spent. That is happening right now, which is why money-printing (or rather its computer-age equivalent, quantitative easing) in the United States and Britain has been so notably unsuccessful.
The General Theory of Employment, Interest and Money, John Maynard Keynes’ great work, was published in 1936. It is vast and complex but is widely known for one central theme: that when private consumption and investment plunge in an economic slump the government should step in with its own spending to take up the slack and to restore demand. Without demand there is no supply; when supply – production of goods and services – drops, people are thrown out of work and can no longer buy things. Demand takes another hit, and so the cycle is repeated and repeated until a depression ensues.
Usually, the only practical way of short-circuiting this process is to inject large amounts of money into productive, employment-creating projects like infrastructure – building roads, ports, schools, hospitals. Only governments can make that sort of investment and they can produce the money, if they want, out of thin air. Or they can borrow. The Australian government chose to borrow, issuing bonds to interested investors, to pay for the highly successful stimulus package which kept this country out of the Great Recession. Those bonds now form the core of a vibrant bond market which was, before, largely missing from the Australian financial scene because our governments didn’t borrow much. Australian government bonds are a favourite ‘safe haven’ for global investors: because our interest rates generally are higher than those in the US, Britain, Japan or Germany, our bonds are one of the few ways they can get a return above zero. And – unlike people investing in the bonds of, say, Greece or Spain, they know they’ll get their money back. About 80 per cent of Australian government bonds are held by foreigners.
Before we go on, a word about what bonds are. They are contracts between the borrower – which might be a government or a big company – and a lender, which might be a bank or other investor. Let’s say the government wants to raise a million dollars. It puts up for sale a bond which promises to pay the million dollars back after, say, ten years; in the meantime it will pay the buyer interest – let’s say of 5 per cent a year. That’s called the coupon rate. So the initial buyer will get $50,000 a year.
What makes bonds different from ordinary loans is that they can be bought and sold on the secondary bond market. This is where it gets interesting: prices paid for bonds on the secondary market go up and down. If the buyer of our million-dollar bond can only get $500,000 for it, the nominal interest rate paid by the government will still be $50,000 a year. But for the new buyer, that is effectively a rate of 10 per cent of what he paid. That’s called the yield. As prices go down, yields go up – and vice versa.
Australian government bonds are in demand on international markets so the prices have been going sharply up. And yields – the return the new owners get on their money – have gone, equally sharply, down. In Greece, Spain, Portugal, Ireland and Italy, the opposite has happened. Bond buyers worry about those governments honouring their debts, so they won’t pay as much for the bonds. This means yields – the real interest rates – go up and up. If yields on a country’s benchmark 10-year bonds get past about seven per cent, that means any new bonds issued by the government will have to carry this unaffordably high interest rate too. So these governments are effectively priced out of the commercial bond market and must beg for a bailout. Greece’s 10-year bonds are at about 27 per cent. At that point, a few per cent hardly matters: Greek government bonds are worthless and the people who bought them – mostly banks throughout Europe – have probably lost their money.
If the Australian example had been followed, the plummeting economies of the eurozone periphery would have been boosted by increased spending on infrastructure. But those governments are, essentially, insolvent: they cannot pay their debts and cannot raise the cash to keep going. More government spending is out of the question. Any economic stimulus would have to come from outside – in the case of the eurozone, from the European Central Bank, the European Commission and the International Monetary Fund. And those would get most of the cash from a buoyant Germany, so the Germans are calling the shots and dictating the terms by which the troubled eurozone governments are given the low-interest loans to keep them going. The demand is austerity – cutting back on government spending. This has been a disaster. It has crippled those already-troubled economies to such an extent that tax revenues are way down. The so-called ‘bailouts’ are loans, not gifts – so they add to government debt in the countries that receive them, forcing those countries even further into the red. Unemployment in Spain and Greece is running at around 25 per cent and youth unemployment at over 50 per cent. Austerity has eviscerated government services to such an extent that Greek public hospitals can no longer afford drugs or even such mundane supplies as gauze and syringes. Cancer patients are cancelling chemotherapy because they can’t afford to pay for it themselves. The suicide rate is rising sharply.
Britain, which has not asked for a handout and is following savage austerity measures as a matter of Conservative Party ideology, is in intractable recession. The Chancellor of the Exchequer, George Osborne, is under attack from his right-wing supporters in business and from the Labor Party on the left. He may lose his job: it would be only reasonable if he does, because his policies have cost millions of his countrymen their jobs.
The lives of a generation are being blighted. Recessions are formally defined as two quarters of negative economic growth. This is no recession. It’s a depression, pure and simple.
Paul Krugman says the United States is in a depression too. There is high and stubborn unemployment, economic growth is bouncing around just ahead of zero and no credible improvement is in sight. He quotes Keynes: ‘[A depression is] a chronic condition of subnormal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse.’ And the way to tackle this depression is the same way Franklin Roosevelt tackled the Great Depression in the 1930s: with powerful, determined stimulus.
In his new book, End This Depression Now!, Krugman puts a detailed, persuasive case aimed at the intelligent non-economist. ‘What makes this disaster so terrible – what should make you angry – is that none of this need be happening,’ he writes. ‘There has been no plague of locusts; we have not lost our technical know-how; America and Europe should be richer, not poorer, than they were five years ago. Nor is the nature of the disaster mysterious. In the Great Depression leaders had an excuse: nobody really understood what was happening or how to fix it. Today’s leaders don’t have that excuse. ‘We have both the knowledge and the tools to end this suffering.’
The first step, he says, is to counter the remaining advocates of fiscal austerity: he calls them Austerians, for their adherence to a bunch of conservative economists concentrated in Austria in the late 19th and early 20th centuries. Their disciples today include those who believe cutting back savagely on government spending while ignoring the crippling effects such measures have on overall economic growth. Austerity policies were widely advocated in the wake of the first round of the global financial crisis after governments ran up huge debts to bail out their profligate and irresponsible banks. The first recipients of so-called bailout money from the European Union, the European Central Bank and the International Monetary Fund – most notably Greece – were forced to slash their budgets because, it was claimed, this would reduce their debt to such an extent that private investors would be prepared to lend to them again.
Austerity has produced severe and unsustainable pain but it has made the sovereign debt problem worse. As government retreated from spending, the private sector did not fill the gap as it was meant to. Fear spread. Consumers stopped buying, companies stopped investing and everyone paid less tax. Governments found their income falling faster than they could slash their budgets. So they kept slashing and the vicious cycle continued.
On the other side of the Atlantic President Obama, despite constant demands by Republicans for budgets to be slashed there too, agreed to a stimulus package soon after his inauguration in 2009. It was a half-hearted response, though, and poorly targeted: enough to arrest the decline in employment but not enough to set the economy on the path of growth. Krugman, and others, predicted at the time that the package would not have the promised effect and would instead discredit the whole idea of stimulus. Sadly, they were right.
But, insists Krugman, time has not removed the urgent need for large-scale stimulus, aimed this time – unlike before – at classic infrastructure spending in the New Deal tradition, not at inefficient tax cuts and benefits. Politically, the chances of this, in an election year and with the Tea Party holding the nation in thrall, seem somewhere near zero.
The key arguments against stimulus are that it will boost government debt, making the situation worse; and that it will fuel inflation. Nonsense, says Krugman.
Government debt is generally measured not in absolute dollar terms but as a proportion of a year’s gross domestic product (GDP), which measures the size of a nation’s economy. What’s important is not the number of dollars involved but the capacity of the whole economy to deal with it. A decent stimulus would expand the economy, the private sector would finally respond, and GDP would go up. As a proportion of GDP, government debt under a successful stimulus would actually fall.
Besides, there are other ways than borrowing of funding a stimulus. Governments, through their central banks, can conjure new money out of thin air. They don’t even have to print it any more. If you or I hacked into our bank accounts and added a few convenient noughts to the total, we would be sent to prison. But central bank governors are employed to do just that sort of thing. It’s known as increasing the money supply.
America and Britain have invented vast amounts of new money to fund their programs of quantitative easing, which is what you do when official interest rates are already at or near zero and you can’t cut them any more. The US Federal Reserve and the Bank of England used their new money to buy government bonds from investors, mainly banks. This gave the banks an injection of cash which, it was hoped, they would lend to companies to build things and get the economy moving again.
Trillions of dollars have been involved to relatively little effect. The banks, worried about the state of the economy, did what consumers are doing: they did not spend but saved. Much of that new money – much too much – has stayed in the banks’ vaults or, more accurately, their computers. It has done little to boost economic demand or production.
Quantitative easing is not stimulus. But there’s nothing to stop a real stimulus package being funded in the same way.
Those who predicted that increasing the money supply would send inflation soaring have been proved vastly wrong. Inflation – that is, the price of goods and services – takes off when demand outstrips the capacity to produce. When you have too many buyers competing for a limited supply of goods, the price goes up. But the problem in most economies, including America’s, is not too much demand but too much underutilised productive capacity. Until that capacity is soaked up – and it would take a truly heroic stimulus to achieve anything of that sort – inflation will stay tame. In fact, in many countries, the enemy is not inflation but deflation. Inflation is bad but deflation is worse. Deflation means recession and depression.
Paul Krugman believes a large-scale US stimulus funded through borrowing is still entirely feasible. Investors around the world, worried about events in Europe, China and elsewhere, are pouring their money into safe-have assets. Much of that money has been going into government bonds issued by nations unlikely to default on their debts – the United States, Britain, Germany, Australia. The demand for these bonds has forced prices up and yields down (as you will recall, price and yield move inversely), creating an extraordinary opportunity for those governments to borrow cheaply. In the end, he says, the most important thing is not the amount of money borrowed but how much it costs to service the debt – and the yields on US government bonds are only just above zero, and well below inflation even in that anaemic economy. Investors are prepared effectively to lose money in order to park their cash with the American government. As stimulus takes effect more people will be employed, more taxes will be paid and the government’s capacity to deal with its debt will grow at a much faster rate than the almost-zero interest it pays on its loans.
But the fears of the world are centred not on America but on Europe. About that mess, Paul Krugman has few solutions, none of them original and none particularly convincing. Nouriel Roubini doesn’t even try. His view is that disaster awaits and there’s not a hell of a lot we can do about it. The world faces, he says, a perfect storm.
Europe, he said in a recent article, is a slow-motion train wreck with only one likely outcome: several countries leaving the euro, devaluing their national currencies and causing crippling losses for global banks. The US recovery is slowing and may reach ‘stall speed’ by the end of the year. Political deadlock in Washington hamstrings any attempt to meet the crisis. China’s growth model is unsustainable. Its investment bust continues, attempts to boost consumption are too little and too late, and dilatory reform efforts will be further disrupted by a leadership transition. Iran is developing nuclear weapons, and any military strike by Israel or the US would cause world oil prices to soar.
Roubini is more pessimistic than most about America and China but well within the mainstream on the Eurozone’s prospects. The euro project tried to create one part of a federation – a monetary union – without bothering about the other elements that are essential for any federation to work. Australia, Canada and the United States – all federal systems – have centralised not only their currencies but also their political, banking and fiscal policies. It is seldom that all parts of a complex state, much less a whole continent, are in equal economic health at any one time. Australia is an example: in the twelve months to June this year, Western Australia’s economy grew by 3.5%, Tasmania’s by 0.8% and Queensland’s by 0.2%. Unemployment was 3.7% in Western Australia and 7.3% in Tasmania. If Tasmania was an independent country, its currency would depreciate against those of its trading partners, making its goods and services (including tourism) cheaper and more competitive to outside buyers and raising the price of imports. In Western Australia was independent the reverse would happen. The hyperinflation in mining areas would be tamed. Through this mechanism, a balance would be struck.
With a single currency, such automatic adjustment is not possible. So, in a functioning federation, there are ways of achieving much the same result. Taxes raised in Australia’s wealthier states fund welfare payments in the slower parts of the economy. The Commonwealth Grants Commission rejigs GST distribution so all states are capable of providing the same level of services. The federal government can use taxes paid by the whole economy to support the car industry in South Australia, Victoria and New South Wales. And federal systems can centrally control the amount of debt each region gets into.
No such equalisation is possible in the Eurozone. In the pre-euro world low-productivity nations like Greece, Spain, Italy, Portugal and Ireland would have been able to devalue their currencies, making themselves more competitive. Germany’s currency would have appreciated, doing the reverse. The peripheral Eurozone countries are less productive than their northern partners, which means it costs more to produce a car in Turin, Milan or Madrid than in Munich. Germany is riding high, benefiting immensely from a currency which kept artificially low by the travails of the south. Transferring payments within the Eurozone is at best clumsy and, more often, impossible. The numerous ‘bailouts’ are very different from Australia’s system of fiscal transfers. The European bailouts are not grants but merely loans at lower interest than commercial lenders would charge. Each bailout adds to the recipient nation’s debt burden. Worse, these loans come with crippling conditions, forcing more and more austerity and plunging their peoples further and further into poverty.
For countries like Greece, Roubini argues, there are only two practical alternatives. The first, reducing labour costs and enforcing massive structural reform, would put Greeks through another decade of depression before the productivity changes began to bear fruit. They are unlikely to stand for that, and nor should they have to. The only other option is to leave the euro.
‘Of course,’ Roubini wrote, ‘the process would be traumatic – and not just for Greece. The most significant problem would be capital losses for core Eurozone financial institutions. Overnight, the foreign euro liabilities of Greece’s government, banks and companies would surge. Yet these problems can be overcome.’ He cites Argentina in 2001 and the US in 1933 as examples.
But what sort of example would that set? Greece’s economy is too small to knock the whole of Europe too far off balance. The fear is contagion would set in: that lenders would abandon larger countries, forcing them out of the euro too, and multiplying the problems so profoundly that large numbers of the world’s banks would go broke and the global financial system would freeze, perhaps for years.
Roubini’s answer is not pretty, but it is straightforward. ‘Those who claim that contagion from a Greek exit would drag others into the crisis are also in denial,’ he wrote in May. ‘Other peripheral countries already have Greek-style problems of debt sustainability and eroded competitiveness. Portugal, for example, may eventually have to restructure its debt and exit the euro. Illiquid but potentially solvent economies, such as Italy and Spain, will need support from Europe regardless of whether Greece exits; indeed, without such liquidity support, a self-fulfilling run on Italian and Spanish public debt is likely.’
In the two months since those words were written, Spanish bond yields have soared to unaffordable levels, effectively pricing Madrid out of commercial debt markets. Italy is going the same way. It looks as if Nouriel Roubini is right again. He may be wrong about the capacity of the rest of Europe to bail out such large economies as Spain and Italy. There just isn’t enough cash in the kitty. So Spain, Portugal and perhaps Italy may also find leaving the euro, with all the short-term pain that would involve, to be their only option.
‘Make no mistake, he wrote, ‘an orderly euro exit by Greece implies significant economic pain. But watching the slow, disorderly implosion of the Greek economy and society would be much worse.’
As we are constantly told, the Australian economy is the strongest of any major developed nation. We have our strengths, most notably our terms of trade. Prices of iron ore and coal have rocketed in the past decade or so but are now coming back to earth. Major resource projects have been put on hold and, once the ‘tail’ of existing resource investment projects runs out in a year or two, the business of building and expanding mines – a big contributor to government coffers – will slump. No economy, including ours, can evade major global shocks like the first stage of the global crisis, which was the last time the mining boom ended. The notion of a mining super-cycle lasting for decades has been exposed as the wishful fantasy it always was.
Europe buys about 20% of China’s exports, America not much less. As export demand falters, Chinese production will fall: manufacturers, whether in China or elsewhere, cannot continue making things nobody will buy. Urbanisation in China, driven by a rapidly expanding export-oriented manufacturing sector, is likely to slow. The demand for Australian iron ore and coal will falter again, as it did in 2008. Fewer taxes and mining royalties will be paid; unemployment will rise and investment will fall; consumers will stop spending and the Australian economy will need the kind of stimulus package that saved our bacon last time.
But by then, the economic buffoons will be in charge: Tony Abbott will be Prime Minister and Joe Hockey will be Treasurer. Ever since the stimulus saved Australia from recession, Abbott and Hockey have slammed it, promising that when they achieve government they will do nothing of the kind. We cannot expect a decisive and effective stimulus from an Abbott-led Liberal government, however many economists tell them one will be needed and however much human misery its lack will cause.
The future resists prediction. Nothing is certain. The Eurozone may, somehow, hang together. America could rebound. Iran could abandon nuclear weaponry. Consumers could start to spend again. If all these things happen, the good times will roll once more.
If we cannot foretell the future, all that is left to us is to deal in risks: what is most likely to happen? Though the Pollyanna scenario remains the stated policy of many nations, including our own, the risk of the opposite happening has been steadily increasing and now appears overwhelming. Few of the world’s leaders have learnt from the past. They have not learnt the lessons of the 1930s or they would not now be applying the nostrums of Herbert Hoover. They have not even learnt from 2008.
The train will not be saved from crashing just because the driver has his eyes shut.
Martyn Goddard has been a journalist at the ABC in Melbourne and Sydney and has worked in national health policy, mostly in the consumer sector, for more than 15 years.