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Thursday, August 16, 2012

Fed Watch: When You Only Have a Hammer

Tim Duy:

When You Only Have a Hammer, by Tim Duy: Soon after we learn that economists are pulling their support for Britain's Chancellor George Osborne, German Chancellor Angela Merkel is back in the news, pounding the table for more austerity. Via Bloomberg:

German Chancellor Angela Merkel renewed her call for austerity as crucial to tackling financial turmoil in the euro area, praising Canada’s economic example as she returned to the crisis fight after her summer vacation.

Merkel, facing European pressure to ease bailout terms and allow shared debt, and from global partners to do more to stop contagion, used a visit to Canada as the stage for her first public comments in a month on the crisis. She hailed Canada’s budget discipline, promotion of economic growth and “not living on borrowed money” as models for the 17-nation euro region.

“This is also the right solution for Europe,” Merkel said at a reception in Ottawa late yesterday before talks with Prime Minister Stephen Harper, according to a transcript posted on the German government’s website. “I will report on our political will to overcome the euro crisis and on our determination in Europe to band together for a common currency.

The problem is, of course, that Canada is the wrong model. Peter Coy of Bloomberg noted this earlier this year when he commented on why Canada was the wrong example for the United States. The basic rational applies to Europe as well:

  • In Canada, austerity helped lower interest rates. Rates are already super-low in the U.S., so there’s no room to improve.
  • In Canada, austerity lowered the value of the Canadian dollar, which made Canadian goods more competitive on world markets. The U.S. is a relatively self-sufficient economy, so it would benefit less from a depreciation, even if one occurred.
  • Canada benefited from growing demand for its products from the U.S. and China, which compensated for the chilling affect of deficit reduction. No countries today are eager to soak up more imports from the U.S.
  • Canada is indeed an exception. An International Monetary Fund study looked at 172 fiscal policy changes in rich countries and found that on average, reducing the budget deficit by 1 percent of GDP reduced output by two-thirds of a percent and boosted the unemployment rate by one-third of a percent.

On the first point, I suspect the European policymakers are hoping that lower interest rates will solve all their problems. To be sure, lower rates will help finance government debt. But lower rates haven't sparked the much-anticipated rebound in the UK, and given the damage done to the European financial system, I would expect the same for Europe.

On the second point, the Merkel doesn't want to believe that currency depreciation has anything to do with a standard IMF rescue program. But you can't just wish that problem away. The Canadian Dollar in the 1990s"


The third point follows from the second. Global trade is already in a slowdown, sapping demand for exports across the board. The challenge is even worse in Europe, where your primary trading partners are also struggling. Moreover, Canada has the benefit of being an oil producer, which has certainly been something of a positive this past decade.

The final point, that history is general does not support the idea of "austerity" booms, already has plenty of examples in Europe right now, examples that Merkel chooses to ignore.

In addition, I would add that Canada benefited from a central bank willing to support nominal GDP growth:


Let's look at the situation in Spain:


It isn't exactly easy to reduce your debt to GDP ratio when the denominator is flat to falling. Simply put, being in the Euro ties Spain, Italy, etc. to the disastrous monetary policies of the European Central Bank. But that is a story for another time.
Bottom Line: Canada is not a model for Europe. If it is a model, it tells us that currency depreciation relative to your major trading partners is an essential part of any austerity program. Not exactly a model that Europe is willing to follow.

    Posted by on Thursday, August 16, 2012 at 11:07 AM Permalink  Comments (46)


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