Thursday, January 24, 2013

Defending the indefensible, Merkel insists on more austerity

In her remarks at Davos, Angela Merkel insisted that austerity must continue to be imposed despite the simple fact that more than 50% of the youth in Greece and Spain are long-term unemployed.

Why does she push austerity?

To defend German bank book capital levels and German banker bonuses.

As regular readers know since August 9, 2007, policymakers have faced a choice everyday as to how to respond to a bank solvency led financial crisis.  They can adopt the Japanese Model and protect bank book capital levels and banker bonuses at all costs or they can adopt the Swedish Model and require the banks to recognize upfront the losses on the excess public and private debt in the financial system.

If policymakers adopt the Japanese Model, they place the burden of servicing the excess debt on the real economy.  At best, this diverts capital that is needed for growth and reinvestment to debt service and produces a stagnate economy (think the 2+ decade Japan-style economic slump).  At worst, this diversion of capital produces a depression (think current economic conditions in Greece and Spain).

If policymakers adopt the Swedish Model, they protect the real economy and the social contract as capital continues to be available for growth and reinvestment in the real economy.

So who loses based on the choice policymakers must make everyday?

If policymakers choose the Japanese Model, the losers are their country's citizens.

If policymakers choose the Swedish Model, the losers are the bankers.

So who wins based on the choice policymakers must make everyday?

If policymakers choose the Japanese Model, the winners are the bankers and no one else.

If policymakers choose the Swedish Model, the winners are their country's citizens.

Clearly Angela Merkel and the German policymakers have chosen the Japanese Model, is there any reason this choice is indefensible besides the incredibly negative impact on society for the benefit of the bankers?

Yes, modern banking systems are designed to support the Swedish Model.  Because of the combination of deposit insurance and access to central bank funding, banks can operate with low or negative book capital levels.

When banks have low or negative book capital levels, deposit insurance effectively makes the taxpayers the silent equity partner of the banks.  As a result, banks can continue to operate and there is absolutely no reason for countries to bailout the banks by injecting funds or protect the banks' book capital levels by engaging in regulatory forbearance or suspending mark-to-market accounting.

Is there any proof that pursuing the Japanese Model results in ending a bank solvency led financial crisis?

No.  Japan is still struggling to end its financial crisis 2+ decades after it started.  In the US, the Japanese Model was pursued at the time of the savings and loan crisis.  It failed and ultimately the vast majority of savings and loans were closed.  However, by pursuing the Japanese Model to handle the crisis, the US financial regulators did succeed in dramatically increasing the cost of dealing with the insolvent savings and loans.

The Swedish Model sounds too good to be true, is there any proof that it works?

Yes.  The first example of the Swedish Model being used was by the FDR Administration during the Great Depression.  According to the NY Fed, adopting the Swedish Model (it wasn't called that in the 1930s, it was called a bank holiday where only the "solvent" banks were allowed to reopen) broke the back of the Great Depression.

There have been other examples including Sweden and most recently Iceland.  Despite some mistakes in implementation, each of these examples showed just how effective making the banks recognize the losses upfront on the excess debt in the financial system is at ending the financial crisis.

Why do policymakers have to make this choice everyday?

Because adopting the Swedish Model is always an option.

Angela Merkel has insisted there can be no let-up in the painful economic reforms being driven across Europe, despite union leaders warning that the risk of social unrest in southern European countries is increasing. 
In a keynote speech at the World Economic Forum's annual meeting, Merkel insisted it was vital to keep driving down labour costs to make Europe more competitive. 
"Were we to meet halfway, we would have accepted that Europe will not be competitive globally," said Merkel, adding that this would cause unacceptable damage to Germany's exporters.
Perhaps I missed something, but it appears that Germany's economy is slowing down as its exports are declining as the austerity it imposes on the rest of the EU closes one of its major markets.

As mentioned above, choosing the Japanese Model is bad for the citizens of the country whose politicians make the choice.
She argued that growth and fiscal consolidation are "two sides of the same coin", disappointing Davos attendees who hoped for a thawing on Europe's austerity drive....
I must really be missing something, but the countries that are pursuing austerity all seem to be in either a recession or depression.  Support for this observation comes from the IMF which after admitting that it underestimated how devastating austerity is to countries in a recession is now urging the UK to end its austerity obsession.
But labour officials in Davos are deeply concerned that political leaders are still failing to address the issue of unemployment
The easing of the financial crisis has lulled many into a false sense of security, warned Guy Ryder, director general of the International Labour Organisation. "I am often asked whether the levels of unemployment in southern Europe threaten social stability. Yes, it does. But you don't have to wait for a revolution to do something about it," said Ryder. 
He was speaking as new data showed that 60% of young Spaniards are now out of work.
Your humble blogger admits to really missing something as zero interest rate policies, unlimited quantitative easing, promises to buy unlimited amounts of bonds for eurozone countries that agreed to be in a permanently depressed state and 60% youth unemployment do not suggest that the financial crisis is easing in the slightest bit.

What the claim the financial crisis is easing suggests is that bankers are once again lined up at the trough to take outsized bonuses that they would not be entitled to if Angela Merkel and the German policymakers were not protecting bank book capital levels.
Merkel insisted current unemployment levels were a price Europe had to pay to become more competitive, and pointed out that Germany had been on the same path, with unemployment hitting 5 million before the public accepted structural reforms.
What her story misses is that the global economy was expanding briskly at that time.  The situation is dramatically different today.
Sharan Burrow, general secretary of the International Trade Union Confederation, said there was "a real lack of political will" to address the unemployment crisis. "Leaders feel the pressure, but there is only a commitment to a jobs plan in a very few countries," said Burrow. 
"They are waking up and worrying about stock markets and rating agencies, rather than things people really care about – such as education, growth and jobs."
The concern with stock markets and rating agencies over the things people really care about is one of the surreal aspects of the ongoing pursuit of the Japanese Model.

The policymakers are so trapped in manipulating the financial system that they lose sight of the fact that their primary concern should be the well-being of their citizens and not the banks and bankers.
Merkel ended her Davos appearance with a plea to global international companies to employ more young people in Europe, to bring them "jobs, peace and hope". She added: "I welcome anyone who will give a helping hand to young people."
She should start the process of giving a helping hand to young people by adopting the Swedish Model and requiring the German banks to recognize upfront the losses on their on and off-balance sheet exposures to the excess public and private debt.

This would be a major step to restoring growth to the eurozone economies and the hiring of young people.

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