How austerity blooms on Keynes’s grave

By Felix Salmon
August 19, 2011
James Macdonald has an extremely valuable way of putting things into stark focus:

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James Macdonald has an extremely valuable way of putting things into stark focus:

The markets have highlighted a fundamental shortcoming in Keynes’s ideas: He assumed that governments would always be able to borrow. If they cannot, then Keynesian economics is dead in the water.

The thesis of Macdonald’s essay is simple and scary — and, I think, correct.

We have been living through, and are now probably witnessing the end of, an era with no historical parallels: what might be described as the “great debt experiment.”

In many ways this is a good thing. We’ve relied far too much, in the developed world, on debt-fueled growth — and that kind of growth rapidly becomes unsustainable in a world where the amount of growth that can be squeezed out of every marginal dollar of debt has been falling steadily for decades.

But deleveraging,which is great from a systemic-stability perspective, has another name in the short term: austerity. And that’s something we’re only starting to get used to, and which is going to get much more painful, especially in Europe, before this cycle has played itself out.

Greece was the first Eurozone country to find itself locked out of public markets; it won’t be the last. And even now, Greece can still borrow: the ECB and Eurozone have enough faith in Keynesian principles that, for the time being, they’re willing to step in as the lender of last resort to troubled sovereigns. But Greece is small enough to save in that matter; Italy, not so much. If the public markets shut out Italy, or if the Eurozone lacks the political will to continue throwing good money after bad, then we’ll immediately enter the most severe crisis of our lifetimes.

Here’s a couple of charts from Spiegel’s excellent slideshow on the subject to put Europe’s sovereign debts in perspective; the second one should be titled “debt”, not “deficit”. But the first one is the scarier one: it just shows the debt coming due by end-2013 in the five crisis countries. We have a serious liquidity issue here, never mind the questions of solvency raised in the second chart.

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The Maastricht limit, of course, is the maximum debt that Eurozone countries are allowed to have. So much for that idea. And debt in general, as we saw in 2008-9, is a treacherous and precarious beast — you never want to push it to its limits. The market will roll over a country’s debts happily and indefinitely — until it won’t. Some countries, like Japan, are relatively safe in that regard: “the market”, there, is domestic savers in a country with a high domestic savings rate. But when a country is reliant on foreign investors to buy its debt, and can’t easily fund itself domestically, it’s playing an extremely dangerous game.

Is that the case in the US? Happily, no — as you might suspect, given the 10-year Treasury yielding 2%. But you’d probably be surprised how much of America’s $14 trillion debt is money we’ve lent to ourselves in one form or another.

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So the US, by rights, should be the last country onto the austerity train. We’re the happy recipient of the global flight-to-quality trade, we fund in our own currency, and we fund largely domestically. (Yes, the “public debts” includes a lot of foreign investors, and even some foreign sovereigns, but all that money being taken out of our paychecks in the form of social security contributions and the like goes a surprisingly long way — it’s forced lending to the US government, and it’s not going away.) There are serious questions about some countries’ ability to be able to continue to tap the capital markets; there are no questions at all about others. The US is, happily, in the latter category: if the Treasury ever stops borrowing, that will be thanks to Congressional edict, rather than due to any reluctance on the part of the markets to roll over debt.

That said, the US is running into enormous political problems just trying to make up with sovereign borrowing what the economy has lost in private-sector borrowing over the course of the recession. If it can’t rise to the Keynesian challenge domestically, there’s absolutely no way it will let itself be dragged into becoming a lender of last resort globally.

Which means that we’re in the final innings of the Keynesian game. If you look at the history of sovereign debt, we started with countries borrowing large sums of money from rich private-sector individuals like the Rothschilds. When those sums weren’t enough, the era of big publicly-owned banks began, and borrowing capacity rose sharply. Then we moved into domestic capital markets, and eventually international capital markets. Each move increased the amount of money available for lending to sovereigns. Finally, when sovereigns get tapped out, they can try to appeal to super-sovereigns: the ECB, the EFSF, the IMF and the like. But those funds are limited, and don’t last long. Hence the move to austerity — the only other option. Or, of course, there’s always inflation — the other way that the ECB can bail out overindebted sovereigns. But that doesn’t seem likely any time soon.

Update: Matt at Obsolete Dogma has a really smart response.

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