Alex Carrick: Austerity Steps into the Spotlight
“Austerity”. You’ve read the book. Now you’re starring in the movie.
It’s what politicians want us to embrace. As they’ve become fond of telling us, “We have to learn to live within our means.”
“We’ve been spoiled and now we’re going to pay for it.”
“It’s simple. Families have to live within their budgets. So do governments.”
It’s the chief lesson learned from the Greek sovereign debt crisis. It’s also, to some degree, a self-serving message adopted many political parties to further their own ends.
The differences lie only in how austerity is to be applied and where it will slice the deepest. Who will be affected most – ordinary people, the unions, corporations, the rich?
Let’s correct one fallacy from the get-go. Government budgets aren’t like the family budget. There’s an arc to the earnings curve of a family. Most employed individuals, say a husband and wife, have years during which they can earn an income.
It’s why the labour force is defined as being comprised of individuals aged 15 to 65. In reality, most people don’t enter the labour force at 15. They improve their schooling in order to earn more money later. So in reality, the peak earning years are between 20 to 25 at the front end and 55 to 65 on the backside. Prior to 20, most children and teenagers are being looked after in one form or another. Near age 65, retirement becomes an issue and money set aside earlier is drawn down to maintain a lifestyle.
Governments derive their “living” from a broad revenue base focused mainly on taxes. There is no beginning and end to their earning years. The potential revenue stream goes on and on.
Governments really can live with debt forever. What Europe has illustrated, however, is that government debt is one thing. Excessive, hidden, buried, lied-about government debt is another matter. That’s because there is a practical consequence.
Most governments raise debt in international financial markets. There is one notable exception and I’ll come to that in a moment. Such international financial markets contain both conservative investors and speculators. The more debt a country rings up, the higher the interest rate it must pay to reward people and institutions who are willing to hold its bonds, bills and other promissory notes. After all, there is some risk involved.
It’s generally conceded that most sovereign governments can live with a debt-to-GDP ratio of up to 100 per cent fairly comfortably.
When the figure starts to approach 150 per cent, however, alarm bells go off. That’s where Greece found itself, particularly after it started to tell the truth about the size of its debt.
Japan is the exception I mentioned earlier. Its debt-to-GDP ratio has crossed above 200 per cent without major consequences because almost all of the money raised has come from domestic sources, i.e., the citizens of Japan. The country hasn’t needed the help of foreign lenders.
For a long time, some of Greece’s real obligations were obfuscated and glossed over. When debt becomes too big a proportion of GDP, interest payments take an inordinate bite out of government revenue.
Investors know this and a vicious circle kicks in. Conservative investors begin demanding ever greater interest rates as a reward for lending such governments money. Speculators begin placing bets that the notes of such governments may become worthless.
As interest rates rise, the ability of the government in question to keep its head above water becomes progressively harder. Its current annual deficit rises alarmingly.
A key benchmark rate for long-term bonds (i.e., 10-years) is 7.00%. Once a country finds itself facing that kind of charge, it will quickly move into the category of nations needing a bailout. Greece, Ireland, Portugal, Spain and Italy have all faced this predicament.
This is where “austerity” makes its first appearance on the stage. Lenders of last result, such as the International Monetary Fund (IMF), may help out distressed nations. But there is always a condition. They must embrace austerity. That mostly means severe cutbacks in government spending. This will come in the form of staffing reductions, salary cuts, less holiday pay, reduced pensions and so on. Or tax increases; or some combination of the two.
The problem with austerity is that it’s likely to limit growth. Modern economies have embraced the Keynesian notion that government spending is a key pillar for supporting activity levels when economic times are slow.
Running large fiscal deficits is the classic policy of pump priming. Therefore, we have a conundrum. And it’s why the U.S. presidential election is so interesting. It’s also one of the reasons why the case for Quebec separation may be a much harder sell this time around, if the question is ever put to a vote again.
Perhaps what’s most surprising is that despite the obvious flaws with the notion, political parties of almost all stripes still think austerity is a good thing. It wasn’t a good idea in the Great Depression. Why should it be adopted now? It’s because of one unique social phenomenon. In nation after nation, the domestic population is aging.
Here in Canada we have what’s known as the baby boom generation. The first baby boomers, born between 1946 and 1964, reached the age of 65 in 2011.
Seniors (i.e., those aged 65-plus) currently make up 15 per cent of the total population. By 2030, their share is projected to rise to 23 per cent. This will place tremendous strains on the public purse in the form of medical care and pension payments.
The U.S. is facing a similar demographic situation. That’s why not only the Republicans – who traditionally advocate smaller government – but also the Democrats are promoting austerity, despite the questionable timing. Ever so hesitantly, our neighbor is climbing out of a deep economic pit.
Austerity now will be a pre-emptive strike to keep the social safety net relatively intact when it will be needed most, in 10 to 20 years. So the argument goes.
The Democrats believe a reasonable level of austerity can be achieved through both spending cuts and some tax increases, primarily on the rich. The Republicans are convinced the desired degree of austerity can only be achieved through massive spending cuts. Keeping taxes low will reward risk takers (i.e., the entrepreneurial class) and a reduced government presence in the economy will spur on the business community. Either way, the future shape of America will be considerably altered after Nov. 6.
As for how the austerity issue may have particular importance at home, there is the matter of the recent election of the separatist-leaning Parti Quebecois in la belle province. Quebec has the highest per-capita debt in the country. It’s also the recipient of billions of dollars each year in equalization payments from the other regions. The province would also have to assume its share of the national debt and there would be additional charges for policing, setting up a military presence and establishing international frameworks (i.e., a passport-issuing office) if it were to go it alone.
The bottom line is that, with the amount of significant debt an independent Quebec would bring to the table, the interest rate required to service it would be substantial. This might bring about our own Greece-type situation north of the 42nd parallel. If that were to come to pass, Premier Pauline Marois might have to approach Stephen Harper for a bailout. It would make for an interesting photo op.
If Quebec were to continue to operate under the umbrella of the loonie, it would be compelled by foreign investors to cut down on its deficit and reduce its debt. Major austerity couldn’t be avoided. If it decided to adopt its own currency, the value would surely depreciate significantly versus the loonie and that would bring its own set of problems, such as skyrocketing prices for imports. Chief among the latter would be oil.
As a final comment, austerity is a concept that has taken hold for the moment. Will it have a long shelf life? I suspect not. Once Europe more clearly finds its groove and the U.S. regains its swagger – and the export-dependent emerging nations return to what they do best, supplying both Europe and the U.S. with low-cost goods – austerity is likely to be wished a not so fond farewell.
Alex Carrick is Chief Economist with CanaData, a division of Reed Construction Data (RCD). CanaData is the leading supplier of statistics and forecasting information for the Canadian construction industry. RCD is a division of the global publishing firm, Reed Elsevier. For more economic insight from RCD, please visit www.dailycommercialnews.com/features/economy. Mr. Carrick’s lifestyle blog is at www.alexcarrick.com and he would welcome a follow on Twitter (Alex_Carrick) or Facebook. www.alexcarrick.com