Readers Question: How sustainable do you think that the austerity measured imposed on European countries are in economic and political terms?

This is a good question. Firstly, I feel there is a certain political appeal of austerity. See: Why is austerity politically popular?

When austerity was introduced, there was a reluctant support for austerity – because of the widely disseminated view it was necessary. However, as time passes and austerity appears to have given more pain than gain, the political support will continue to dwindle.

A politician promising to ‘get tough on debt’ has a certain political capital. A politician promising to bring in counter cyclical budget policies is  (firstly, is very rare) and also likely to get ignored or mis-understood. There is growing criticism of austerity, but it is a rare to hear a politician talking about – targeting full employment, running a bigger cyclical deficit and / or monetising debt.

There are a few issues:

Unemployment is a marginalised political issue

Eurozone Unemployment

In my opinion, unemployment is one of the greatest personal finance disasters and one of biggest economic / social problems facing society. It is not just a loss of income, but also a loss of self-esteem because you don’t have the opportunity to contribute to society. But, there never seems to be the same political urgency to tackle high unemployment. When the Coalition government was elected in 2010, the impression I got is that they were more concerned with reducing the budget deficit than tackling unemployment.

The ECB seem to live in a bubble where they define economic success as achieving an increasingly meaningless inflation target, budget deficit reductions and lower bond yields.

However, with unemployment rates in Europe continuing to increase, it may become a bigger issue amongst the electorate. If European policy makers don’t engage with the unemployment issue, there may be an increased gap between the unemployed and policy makers.

Austerity hasn’t worked

Generally, a temporary rise in unemployment and fall in GDP can be shrugged off. However, the problem with the austerity policies of the last few years, is that they have left Europe in continued difficulty. Even by a very narrow view – measuring success by debt to GDP targets, it has often failed (Austerity self-defeating). Some of the worse affected countries like Greece, Italy and UK are failing to stop the rise in debt to GDP.

EU debt

But, in the bigger picture, austerity and monetary inflexibility are contributing to a significant double dip recession. Unemployment for 6 months is one thing, but a rise in long-term unemployment is much more serious.

The problem Europe faces is that it is hard to see where strong economy recovery is going to come from. With tight monetary, tight fiscal policy and fixed exchange rates, there is an inertia – preventing economic recovery and reducing unemployment. Even countries who don’t need to pursue austerity – Germany and Netherlands have embraced the trend for cutting spending. The consequence has been to push European growth lower. There is a real danger of a lost decade; we already have lost half a decade.

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Readers Question: In response to the post on ‘printing money, imports and inflation’, why can’t the British government just print lots of money and import goods from abroad to relieve the pressure on its budget?

In theory, they could do that. But, if you print money and spend it on imports, you would see a significant depreciation in the exchange rate. The British government can print Pound Sterling, but to buy imports they have to increase supply of Sterling on the foreign exchange, leading to a lower value of Sterling.

With a big increase in import spending, there would also be a deterioration in the current account. Though the depreciation in the exchange rate would offset this because the depreciation in the exchange rate makes exports more competitive.

The problem of the depreciation in the exchange rate is that it would lead to imported inflation. The price of imports rises and this contributes to cost-push inflation leading to lower living standards. There would also be a concern that a depreciation in the exchange rate may cause exporters to have less incentives to cut costs and improve efficiency because they can rely on the ‘easy’ option of a depreciation.

Also, there would be an adverse impact on market confidence. Ff the government  printed significant amounts of money to buy imports, it would discourage foreign investors from holding UK bonds. Because foreign holders of UK bonds would see a fall in the value of their UK investment.

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Readers Question: I’ve recently been studying monetarism and I have a question with regards to printing money. It is well known than printing money leads to inflation as demonstrated by the Fisher equation, but say if the new money created was all spent on imports i.e. all the newly printed money leaked from the domestic economy, would printing money in this scenario still lead to inflation? I am inclined to say yes because of an appreciation of the exchange rate due to increased expenditure on imports, but I would like some clarification and I would also like to hear from your ideas and thoughts.

Assuming certain conditions, there is a rough link between the money supply and inflation

The quantity theory of money MV = PY is true from a theoretical perspective.

However, it makes several assumptions so the link between the money supply and inflation is more tenuous – especially in a liquidity trap and the conditions we see at the moment.

The basic quantity theory of money assumes a closed economy. If you print money this increases the money supply in the UK. But, if this extra money gets all spent on imports, then the money leaks away from the UK economy and the money supply in the UK will be unchanged. (Unless we spend on imports in Europe, and this increase in demand for European goods caused Europe to have a much bigger increase in demand for UK exports. Then we may see money coming back into economy)

Similarly, if the Central Bank increased the monetary base, this doesn’t necessarily increase the broad money supply and inflation. We know from the experience of quantitative easing in the UK, that we can see a large increase in created money, but it doesn’t necessarily lead to inflation. Commercial banks sold bonds and increased their cash reserves, but because the banks didn’t want to lend the extra money, the impact on M4 and inflation was minimal.

US monetary base expansion

Increase in monetary base, led to big increase in commercial bank deposits at Federal Reserve.

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