When Will Policy Stop Protecting the Well-heeled?


It is only natural in any human society that government policy should be overwhelmingly oriented towards defending older, vested interests in the economy. To a large extent, the vested interests are the economy. Yet taken too far, this becomes a case of protecting those with wealth at the expense of those without, and cutting off the possibility of economic growth in the future to protect the bank balances of the older generations. At some point it becomes unsustainable, as the need for economic growth in the future has to ultimately override all else, although politicians often take their time in getting round to that conclusion, making the eventual crisis even more painful that it would otherwise have had to be. Let’s take a few overseas examples before discussing Britain.

Argentina

Argentina is still in the IMF’s doghouse for its sovereign default of 2001. As the country’s debts spiralled and economic growth was hit by the rise in the value of the US dollar, to which the Argentine peso was pegged, increasing doubts were registered over the sustainability of the peso peg to the dollar. With bond yields rising, Argentina borrowed from the IMF and the World Bank and was forced into unpopular policies such as a 13% across-the-board cut to civil service pay. At one point the country was paying some of its civil servants in IOUs, and unemployment rose from 14.7% in July 2001 to 20% by December that year, whereupon the IMF refused to release the next tranche of its loan package, as Argentina had not met previously agreed budget deficit reduction targets, and the IMF was demanding a further 10% cut in spending.

In early December 2001, amid a run on the banks, the government introduced a measure called the corralito, allowing people access to only $250 of their savings per week, cutting off access to the bulk of people’s savings for a year. The cacerolazos (demonstrations characterised by banging pots and pans) eventually led to a state of emergency as violence spread, and on December 21st 2001, the president fell from power, fleeing the presidential palace by helicopter. When a government was finally cobbled together, in the closing days of the year, Argentina—one of the largest borrowers in the developing world—defaulted on most of its public debt. After one week in office, the new president also fell from power, being replaced by yet another president. In January 2002, the new president abandoned the 1:1 peso-dollar peg, and all dollar bank accounts were compulsorily converted into pesos at an exchange rate well below the black-market rate, at a stroke removing most of the wealth of middle-class Argentinians, who were powerless to get at their US dollar savings due to the corralito.

Th economy contracted by more than 10% in 2002. Imported goods were unaffordable due to the devaluation of the peso—which fell to a fraction of its former value—even as salaries remained low. Many people were forced to resort to barter and scavenging in the streets, but by 2003 the economy, fired up by devaluation and the repudiation of the government’s debts, was back to strong growth. As Argentina refused to honour its debts, most of the holders of its bonds were forced to agree to swap their bonds for new bonds with much smaller face values and longer terms, in order to get at least something back.

Argentine GDP growth rates (%)

1999

-3.4

2000

-0.8

2001

-4.4

2002

-10.9

2003

9.0

2004

8.9

2005

9.2

2006

8.5

2007

8.7

2008

6.8

2009

0.9

2010

9.2

2011

8.9

The sharp GDP fall of 2002 was followed by a tiger economy performance that has been maintained ever since. Even in the difficult year for the global economy of 2009, Argentina still recorded positive growth, and last year GDP growth was 8.9%. It must be admitted that the default was a runaway success for Argentina, seen in the round, but the middle class lost out. The Irish Independent explained:

As the value of Argentina’s currency plummeted, the savings of middle-class Argentinians began to disappear and some had to resort to begging on the street for food. During the height of the crisis, nearly 60pc of the country—which a century earlier had been one of the world’s richest—was living at or below the poverty level. [The Irish Independent, “The middle classes were begging for food in the street”, July 30th 2011.]

Those who had already built up six- or seven-figure bank accounts saw most of their savings wiped out, but the economy as a whole returned to strong growth. So the policy of sticking to the currency peg and servicing debts that should not have been taken on in the first place was just defending the wealth of the older generation. The only way younger generations could gain their chance at employment and wealth creation was by a policy that wiped out the existing vested interests.

Iceland

In Iceland’s case, the country’s banking-sector debts exposed during the 2008 global crisis were simply too large for the state to seek to bail out, and so the country was forced to take the banking collapse on the chin. Iceland tried to peg its currency to the euro, and then was forced to abandon the peg days later, and restrictions on the purchase of foreign currency were introduced in Iceland. Depositors abroad in the UK and the Netherlands lost access to their savings, the stockmarket dropped by 90% in terms of market capitalisation, and the economy entered a sharp downturn, before a fairly quick recovery.

By not standing behind the banks, Iceland has avoided the bankruptcy of the state. Attempts by the UK and the Netherlands to put pressure on Iceland to compensate depositors abroad were rejected in referendums in Iceland in both 2010 and 2011—fortunately for Icelanders, the Icelandic president refused to accept the deals agreed to by Iceland’s politicians and insisted on referendums. By early 2012, 15-20% of Icelandic mortgages had been written down, reducing the outstanding debt to 110% of households’ pledgeable assets in a way that may not have heartened the bankers, but allowed the real economy to recover. The following GDP growth rates have been recorded:

Icelandic GDP growth rates (%)

2008

1.0

2009

-6.8

2010

-4.0

2011

3.1

From this chart, it can be seen that Iceland took the hit to growth and moved on without overburdening the state with bad debts: the unemployment rate in Iceland (reported at 6% in July 2012) has fallen sharply and is now well below equivalent rates in countries such as the UK. Had the state attempted to protect the vested interests of the banking sector, it is likely the economy would have remained in a deep slump.

Ireland

Ireland has often been compared with Iceland, because Ireland took the opposite route of standing behind the banking sector following an unlimited state guarantee of the banks in 2008, ultimately requiring the state to take over most of the Irish banks and thereby imperilling the creditworthiness of the state itself. The failure to let the banking collapse take its course, as in Iceland, was followed by huge pressure from the EU for Ireland not to “burn” the banks’ senior bondholders, mainly eurozone financial institutions in France and Germany. The EU/IMF “bailout” of Ireland consequently amounted to a bailing out of the eurozone senior bondholders instead. The debt was not originally the Irish state’s debt, but by guaranteeing the debt and not imposing losses on banks in France and Germany, Ireland “voluntarily” decided to mortgage the future of the Irish people.

An alternative would have been to leave the euro and convert banking-sector debts into equity, with the European Central Bank being told that its “bailouts” had bought it large equity stakes in Irish banks, which were no longer in the hands of the Irish taxpayer. There would doubtless have been winners and losers under that scenario, as there were following the Argentine default, but the beauty of it would have been that Ireland became much more competitive overnight. Instead what has happened is that following a large slump, the recovery remains some way off (as shown in the following chart of Ireland’s GDP growth performance), and the slight improvement in 2011 is expected to be followed by a further lurch into recession in 2012. Not only does the failure to leave the euro remove the boost that could have been received from currency devaluation, the Irish state has burdened itself with large debts, which will limit growth rates for a generation to come. The concern to prevent an even larger hit to the state-owned banks also prevents a renegotiation of mortgages, saddling the Irish people with excessive debts for a generation to come.

Irish GDP growth rates (%)

2007

5.2

2008

-3.0

2009

-7.0

2010

-0.4

2011

0.7

Greece

The adherence to the euro has also led the Greeks into a deeper and deeper slump, making it harder and harder for debt obligations to be serviced and requiring a number of bailouts from the EU and the IMF, each requiring more and more austerity, prolonging the recession yet further. The following chart of Greece’s GDP performance does not give the full picture: a reduction in output of around 7% is expected in 2012 too:

Greek GDP growth rates (%)

2007

3.0

2008

-0.2

2009

-3.3

2010

-3.5

2011

-6.9

There would be winners and losers locally from a policy of leaving the euro: reintroduction of the drachma would swiftly reduce the wealth of the Greek middle classes (at least as measured in euros or other hard currencies) as the drachma underwent a sharp devaluation. The long process of changing over the currency would be accompanied by a flight of capital from Greek banks, probably destroying the banking system and necessitating a state bailout (presuming that Greece, like many other economies, would not stand aside and allow the banks to collapse without intervening). Imported goods would become prohibitively expensive.

Yet on the plus side, as in Argentina, devaluation and repudiation of debts would give the economy a shot in the arm. Freed from the need to service debts that cannot feasibly be repaid, which are the legacy of past policy failures, the Greek state would be much closer to balancing its budget, and Greece would quickly regain competitiveness. Once again, it is the same story of protecting vested interests. Not only has the state been anxious to prevent the local banking system from collapsing, the various bailouts have sought, in fact, to bail out Greece’s French and German creditors. The result of the bailouts has been to decrease the proportion of Greece’s debts owned by private-sector creditors and increase the proportion owned by the European Central Bank, now creating the risk of a shock to the ECB’s balance sheet from a Greek default, with repercussions for all eurozone states. Finally, as with all of these cases, those who have wealth in Greece—the rich, the property owners—are having their interests protected, at the expense of the economic growth required to allow the young to find jobs.

Where the majority of the young are out of work, but the Greek middle class have not suffered the redenomination of their bank accounts and other wealth into devalued drachmas, it is clear that those who never had the opportunity to gain wealth in the first place are paying the main price for Greece’s euro crisis. As in Argentina, it is preferable to adopt policies that allow for rapid debt deleveraging—even via a sovereign default—than to soldier on and on with greater and greater debts to protect those at home and abroad who already have wealth. It is undoubtedly the case that an exit from the euro would occasion a huge social dislocation, with millions of Greeks reliant on soup kitchens and even a possible imposition of martial law, but within a year or two Greece could well be back to rapid growth. The course of the Greek crisis seems to be out of the hands of the government, however, and an exit from the euro later this year may become unavoidable. That will be something well worth watching: for the EU authorities, the very worst outcome would be for Greece to get back on its feet and resume rapid growth on the Argentine model.

Spain

Spain is the latest “victim” of the eurozone crisis, with markets imposing higher and higher interest rates on Spanish government debt. Of course, the EU policy response of imposing greater and greater austerity is likely to prevent a resumption of rapid growth, and Spain is expected to record negative growth again this year, following a poor performance in recent years as shown in the following chart of Spanish GDP growth rates:

Spanish GDP growth rates (%)

2007

3.5

2008

0.9

2009

-3.7

2010

-0.1

2011

0.7

As concerns grow over the creditworthiness of Spanish banks, speculation over bank runs is rife, and the end result could be government bailouts of the banks, resulting in a huge increase in Spanish government debt. None of the eurozone economies has the right to issue currency—the ECB controls the zone’s monetary policy—and so an increase in government debt would make it harder for the Spanish state to issue bonds at sensible rate of interest to cover its deficit. A return to growth that allowed the banks to avoid a state bailout is required, but this is prevented by the austerity policies imposed by the EU, which is seeking a reduction in Spain’s budget deficit, in the middle of the slump, lest a mutualisation of government debt be required across the eurozone economies.

Worst of all is that Spain, unlike Greece, is too big for the EU to bailout. Current discussions of a potential bailout are for a figure of around €500bn, dwarfing the sums the EU has available for bailouts. At some point, like Greece, a return to the national currency may be required, which would have the effect of devaluing the wealth of the middle classes, while restoring competitiveness. The property bubble, which is the root cause of the banking sector’s problems, has been popped, but the government would be well-advised not to throw good money after bad and stand behind the banking system. If banks fail, they should be allowed to close and restructure on the Icelandic model.

UK

This discussion brings us to the situation of the UK. While we are not in the eurozone, our property bubble and the huge run-up in public-sector expenditure have left the economy saddled with both private- and public-sector debt, exacerbated by the government bailout of our largest banks. The government’s policy seems devoted to keeping the show on the road, with low interest rates preventing the complete pricking of the property bubble and also allowing the government to carry on spending like no tomorrow. Low interest rates are in turn aided by “quantitative easing”, the electronic generation of money to enable the government to buy its own debt and thus keep bond yields low. From the following chart of UK GDP growth, it is clear that we are not on the verge of an economic recovery, but continue to bump along the bottom, and 2012 has seen a new lurch into recession:

UK GDP growth rates (%)

2007

3.6

2008

-1.0

2009

-4.0

2010

1.8

2011

0.8

This policy, while failing to provide for a new round of economic growth, has the dubious advantage of supporting the vested interests that gained the most during the boom that ended in 2008. Refusing to seriously cut the state keeps the public sector well-financed. There have been cuts in the public sector, to allow for the greater interest payments required to service debts, but the overall total of public expenditure continues to move ever higher. Similarly, low interest rates keep mortgage payments lower than they would otherwise have been—not, of course, in order to protect the property owners, but in order to protect the bailed-out banks. The state, the banks and property owners are all bailed out to various degrees by this policy.

The result is to put our economy in stasis. While restructuring the public sector would cause redundancies, this is the only way that the wider economy can be given the space to grow sustainably. Allowing the banks to fail would cause financial dislocations, but countries such as Iceland have managed such problems. Presumably, the UK is much more central to the global financial system than Iceland, and problems in our banks could lead to a wider collapse, but as the current situation unfolds, it is by no means clear that current policies of forestalling global financial crisis will be successful: as countries such as Argentina have found, giving in to the inevitable is, beyond a certain point, not a choice; it is something that markets may take out of politicians’ hands, and so the hard choices need to be faced up to, despite the fallout they may occasion. Finally, the failure to burst the property balloon has put the property market in stasis, with few homes changing hands, as property owners refuse to lower their prices and mortgages become impossible to obtain. Thomas Pascoe, a blogger for the Daily Telegraph website explained the way in which the interests of the disadvantaged (the low-waged, the unemployed and those without property) are being subordinated to those with wealth in the current policy mix:

If that is confusing, look at what Left-wingers recommend on a national level. They have only two ideas when it comes to ending the financial crisis.

Their first idea is that the government should borrow more and spend it. This ignores the fact that such money will need to be repaid and that the debt burden on those who can least afford itlow-income earnersis already making life very difficult for them.

The result of this policy is incredibly socially conservative. Nothing could do more to entrench the existing social order than building up debt levels which will require abnormally high income tax rates for generations.

High income taxes prevent social mobility because they inhibit the ability to individuals at the bottom of the ladder to build up sufficient capital to own property, meaning that such property can then only be acquired through inheritance. This is a situation compounded by the fact that the one levy Labour did raise the threshold on significantly while in power was inheritance tax.

More “intellectual” Leftists advocate printing large amounts of money and doling said money out to banks, à la Paul Krugman.

Again, this plan is manifestly harmful to those at the bottom of the ladder. Printing money is fine if you are asset rich, because the price of the asset adjusts upwards when the money supply increases. If you are on a fixed cash wage with no or few material assets, as the traditional Labour voter is, such money printing destroys you. Your wage is now worth less but you have not experienced nominal gains in value for property because you do not own any. [“Why the economics of the Left benefit the one per cent”, Daily Telegraph website, July 31st 2012.]

While sovereign defaults, hyperinflation and other extreme economic events that are among the more lurid forecasts if things really go wrong are not really what libertarians would like to see in the economy, at this point we are dealing with a poor range of choices. Continuing with a poor policy mix out of inertia or in order to support vested interests will only prevent renewed economic growth, which, in the end, is the only important thing.

Cutting the state would create unemployment, but allow for private-sector growth in a lower-taxation environment. Banking-sector collapses may be disguised by the earlier erroneous policy of taking large public-sector states in the banks—the state shares should be sold off, even at huge discounts, as soon as possible—but in any case, a property collapse would allow a new set of home owners to purchase at reasonable prices and afford space for financial services activity to improve as home loans are extended based on more realistic valuations. Socioeconomic problems as a result of economic slump can be worked through, as shown in Argentina, but only on the basis of a develeraging of the debt burden of the private and public sectors. The greatest tragedy of all would be to keep on prolonging the final reckoning, allowing vested interest rates to stumble on, at the cost of decades of lost economic growth.

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3 responses to “When Will Policy Stop Protecting the Well-heeled?

  1. In the final paragraph, “public-sector states” should read “public-sector stakes”, and “vested interest rates” should read “vested interests”.

  2. Good article, would also be interested in growth of real living wages for these countries too.

  3. JFen – you would be interested to read the growth of real wages in those economies – but you could be self-starting and not wait for someone to provide you with everything. Why don’t you research itself on the Internet and post the information here? I don’t have time to spoonfeed you.