Why We Should Build The Death Star

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In January 2012, Zero Hedge made a sarcastic proposal to boost US GDP by $852 quadrillion — building the Death Star, a fictional moon-sized space station from the Star Wars film series:

Building a massive space weapon is all very well, but you have to find the materials to build it with. It’s easy to say that “sure, the Death Star would be expensive” but is there actually enough iron in the Earth to make the first Death Star? Centives decided to find out.

We began by loo king at how big the Death Star is. The first one is reported to be 140km in diameter and it sure looks like it’s made of steel. But how much steel? We decided to model the Death Star as having a similar density in steel as a modern warship. After all, they’re both essentially floating weapons platforms so that seems reasonable.

Scaling up to the Death Star, this is about 1.08×1015 tonnes of steel. 1 with fifteen zeros.

Which seems like a colossal mass but we’ve calculated that from the iron in the earth, you could make just over 2 billion Death Stars. You see the Earth’s crust may have a limited amount of iron, but the core is mostly our favourite metal and is both very big and very dense, and it’s from here that most of our death-star iron would come.

But, before you go off to start building your apocalyptic weapon, do bear in mind two things. Firstly, the two billion death stars is mostly from the Earth’s core which we would all really rather you didn’t remove. And secondly, at today’s rate of steel production (1.3 billion tonnes annually), it would take 833,315 years to produce enough steel to begin work. So once someone notices what you’re up to, you have to fend them off for 800 millennia before you have a chance to fight back. In context, it takes under an hour to get the steel for HMS Illustrious.

Oh, and the cost of the steel alone? At 2012 prices, about $852,000,000,000,000,000. Or roughly 13,000 times the world’s GDP.

The point was one against fiscal stimulus — while it may be possible to boost GDP by any amount through government spending, there is no guarantee whatever that that government spending will do anything productive. After all the toil and effort of building a Death Star what is an economy left with? On the surface of things, a giant metallic orb in space and very little else. In Misesian terms, this would be seen as a massive misallocation of capital, resources, labour and technology, building something that nobody in the market demanded and which could be ostensibly used to oppress people (“do what we say or we’ll fire our laser cannon at you!”).

Yet, I am going to try to defend it. I think that building the Death Star, or something similar is a very good idea and would have massive beneficial economic effects for employment, output, science, technology and so forth. And furthermore, I think it is possible in the very, very long run for a government to build the Death Star or something similar of a smaller scale without misallocating any capital, labour, technology or resources whatever.

First, I think that right now humanity is sitting in dangerous territory. There are over seven billion of us, yet we are all concentrated on one ecosystem — the Earth, with one tiny totally-dependent off-planet colony (the International Space Station) that houses less than ten people at a time. Simply, in our current predicament we are incredibly exposed. A single mass viral pandemic, asteroid strike or other cataclysm could completely wipe our species out. With humanity spread throughout the solar system (and preferably, the galaxy and the universe) our species is far less fragile to random extinction events. The Death Star itself — a giant space weapon — would be a safeguard against a particular kind of cataclysmic risk, that of hostile alien attack. If there are other advanced lifeforms populating our universe, they may see life on Earth and especially humans as an existential threat. Having a large, powerful weapon like a Death Star could be a strong safeguard against our own destruction by other species.

Zero Hedge’s mock proposal is actually quite thin, only taking into account the resource cost of the steel, and not the cost of getting the steel into space, building a moon-sized steel satellite in space, presumably including the development of laser cannon technology, some kind of propulsion system, the feeding and housing of a large permanent crew including oxygen and water recycling facilities, hydroponics and artificial food technologies, a transport system to get people and things between the Earth and the Death Star, etc. Nor does it take into account the cost of the labour in employing scientists and technologists to develop and prototype the technologies, employing engineers to deploy the technology, and employing labourers or automated robots to produce components and parts and to assemble the finished article. Simply, the cost would far exceed even what Zero Hedge projects, possibly by many times over.

So why the hell would I think that committing to spend vastly more than global GDP on a single project that nobody in the market is demanding is a good idea? Have I completely lost my mind, and any concept of sound economics that I once had? Well, on a potentially infinite timeline, such a huge figure (let’s say the necessary figure is ten times what Zero Hedge estimated, which could still be rather low in my honest opinion) pales into insignificance as we go further along the timeline. Building the Death Star is not currently a short term project that could be done to boost GDP in a single year to make up an output gap, deploy idle capital or reduce unemployment. In fact even if we committed to building the Death Star today, it is highly unlikely that we would actually even begin work on it in the next 100 or even 200 years. There would be vast technological, social and organisational challenges ahead before we could even begin to think seriously about commencing production. What we would begin work on are challenges far more modest and far closer to our present capabilities — sending a human to Mars, setting up a permanent base on the moon, setting up a permanent base on Mars, and developing technologies for those purposes — specifically multi-use lifters, a space elevator, improved solar energy collection and storage, improved nuclear batteries, improved 3-D printing technologies, higher energy particle accelerators, space mining technologies, robots, machine learning, computing, life support systems and things as mundane as increased science and science education spending.

Those kinds of tasks are much, much, much lower cost than actually committing to building the Death Star in one go, and can relatively easily be funded from presently idle resources (thus not misallocating any resources) as measured by the output gap which currently sits at around $856 billion (5.8% of potential GDP). The United States (alongside like-minded countries with similarly large output gaps) could fund a manned mission to Mars ($6 billion), build a new high energy particle accelerator ($12 billion), give ten-thousand million-dollar basic research grants ($10 billion), build a base on the Moon ($35 billion) and invest $20 billion more in science education for less than 10% of the current output gap. Better still, NASA and space-related spending historically has a relatively high multiplier of at least $2 (and possibly as much as $14 for certain projects, as well as a multiplier of 2.8 jobs for every job directly created) of extra economic activity generated per dollar spent. Given that space-spending yields new technologies like global positioning systems, satellite broadcasting, 3-D printers and memory foam that lead to new products, this is unsurprising. It also means that such spending is likely to get the economy back to full employment more quickly. Once this round of projects is completed, we will have a better idea of where we need to go technologically to be able to build a Death Star. The next time the economy has a negative output gap and unemployment, a new series of large-scale projects can commence. Eventually, with the growth of technology, automation and knowledge, a project on the scale of the Death Star may become not only economically viable but a valuable contribution to human capacity.

Many free market purists will wonder what the point of all of this is. Didn’t the Soviet economy collapse under the weight of huge misallocation of capital to large-scale grandiose projects that nobody wanted? What about all the projects that could have been undertaken by the free market in the absence of such a grandiose project?  My answer to this is twofold — first of all, I am only proposing deploying idle resources that the market has chosen to allow to sit idle and unproductive for a long time. Second, there are some projects that are actually important but which are not currently viable in the market. Space technology is probably the most obvious example. While I greatly admire the new generation of space entrepreneurs, and while I concede that long-term space colonisation will be undertaken be private individuals and groups (in the manner of the Pilgrim Fathers who colonised America — people seeking the ability to live by their own rules, instead of those of established Earth-based jurisdictions) the private space industry is still a long way behind where states were forty or fifty years ago. The Apollo program that put human beings on the Moon has still not been matched by private enterprise.

Ultimately, the Death Star itself is far beyond current human capacities, and far beyond the capacity of the idle capital, labour and resources that we have the option of using up through public initiatives. This I must concede. But, as a super-long-term goal, the capacity to build such things is what our civilisation ought to aspire to. And getting to such super-long-term objectives requires investment and investigation today.

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On The Debt Ceiling & Drowning the Government in the Bathtub

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The mainstream coverage of the debt ceiling standoff and the prospect of government shutdown and how that thing is seen by the people who might precipitate it is predicated upon a fundamental misunderstanding. To the Tea Partiers and Grover Norquist-Ted Cruz-Rand Paul wing of the Republican Party, a government shutdown is seen less as a potential disaster in which markets and society are sent into turmoil, and more as a potential wonderland of enforced austerity where with the government handcuffed, the creative forces of the free market are finally unleashed.

The libertarian financial analyst Mish Shedlock exemplifies these sentiments:

Looking for a reason to support a government shutdown? If so, please consider Obama Stripped to Skeleton Staff in a Government Shutdown.

Mish points to the austerity measures the government would be put under:

 A U.S. government shutdown means President Barack Obama will have fewer people to cook meals, do the laundry, clean the floors or change the light bulbs, according to a White House contingency plan.

About three-fourths of president’s 1,701-person staff would be sent home. The national security team would be cut back, fewer economists would be tracking the economy and there wouldn’t be as many budget officials to track spending.

Of the total, 438 people work directly for the president. Under a shutdown, 129 could continue working, according to the contingency plan.

Biden, who has a staff of 24, would have had to make do with 12.

Obama’s national security staff of 66 would be cut to 42. Similar staff cuts would be imposed at the White House Office of Management and Budget, the Council on Environmental Quality, the Council of Economic Advisers and the Office of National Drug Control Policy, which are all part of the president’s executive office.

Mish concludes:

Fantastic Idea

If you think that a government shutdown is a fantastic idea (I sure do), then please contact your elected representatives and let them know.

But there are at least two other factors beyond simply wanting less government that may make a government shutdown and debt default attractive to the Tea Party wing.

The first of which is that the austerian worldview exemplified by the Wall Street Journal editorial page — in which large-scale deficit spending was expected to precipitate soaring interest rates and inflation — has largely been proven wrong by events. Interest rates and inflation have remained low. The Tea Party wing of the Republican Party now has an opportunity to try to make their initially wrong predictions come true by throwing the United States into default on its debt, and sending a message to markets and international investors that the US government and US Treasury debt is not a safe asset. Whether or not a government shutdown would actually result in a debt default (the Treasury would under such an eventuality likely prioritise debt service), and whether this would actually lift interest rates significantly are other matters, but shutting down the government and defaulting on the debt would certainly enforce austerity which is what the Republicans and especially the Tea Party wing want.

The second — and perhaps the greater factor — is the desire to prevent Obamacare taking effect. Now, I am not convinced that Obamacare can bring down healthcare costs as much as a Canadian-style or European-style system. Obamacare is certainly not an ideal system, although its earlier implementation in Massachusetts does appear to be fairly successful . But it does bring the United States much closer to something approaching universal coverage. With the message of the last Republican election campaign being that 47% of the population (the “takers”) is mooching off 53% of the population (the “makers”), Obamacare is seen by the Tea Party wing and probably the Republicans in general as the last turning point on the road to socialism. And avoiding the implementation of Obamacare is something that, I think, the Republican Party and especially the Tea Party wing will go all out to do.

Now, how far the Republicans are willing to go down this road remains to be seen. The more moderate wing may be willing to settle for a deal that avoids government shutdown in return for increasing the pace of austerity. But the impending implementation of Obamacare, and the general attraction of a government shutdown will strengthen the will of the Tea Party wing to not negotiate.

Personally, while I do think we are in the long run headed toward a world of increased decentralisation and a lesser state role (primarily as the result of technology), I don’t think a government shutdown will do anything to advance the cause of human liberty. In fact, I think a longer-term shutdown would probably end in civil unrest — a lot of people are dependent on government spending for income — and market turmoil (not least because markets seem to have priced in an easy resolution to the standoff). So the standoff will almost certainly end in a deal permitting a debt ceiling increase. How much carnage will occur before then remains to be seen.

Obama Talks Bubbles & Bubble Avoidance

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Barack Obama is focusing his economic rhetoric on the dangers of bubbles:

President Barack Obama, who took office amid the collapse of the last financial bubble, wants to make sure his economic recovery doesn’t generate the next one.

Obama this month spoke four times in five days of the need to avoid what he called “artificial bubbles,” even in an economy that’s growing at just a 1.7 percent rate and where employment and factory usage remain below pre-recession highs.

“We have to turn the page on the bubble-and-bust mentality that created this mess,” he said in his Aug. 10 weekly radio address.

In the long run, this goal — of avoiding inflating economic bubbles that change the structure of production both as they inflate and deflate — is laudable. The best manner in which to achieve it is through the teaching and discussion of history. A key qualitative factor in most bubbles seems to be the forgetting of history, the sense that this time is different, the sense that we may have reached a new stable plateau upon which asset prices can only rise. With the rise and popularisation of notions like the Great Moderation or the end of speculation, investors put down their guard and increasingly engage in riskier behaviours, like flipping condominiums, or buying stocks with leverage. The bubble is a mentality — risks will remain at bay, sentiment will remain high, externalities won’t disrupt activity. This is fine if the risks that investors have begun to ignore never materialise, so not every asset that soars in price is a bubble. Many asset classes including treasuries and junk bonds today are at record high prices, but the Fed is determined to do whatever it takes, and so sentiment has held in spite of naysayers like Marc Faber and Peter Schiff talking of the inevitability of a crash since the recovery began in 2009. The risks have so far remained at bay. But very often the risks that are assumed to have gone away reappear, and all it takes for the market to go into freefall is for sentiment to turn and investors to start selling. Asset valuation is not a question of fundamentals. It is a question of abstractions away from fundamentals. As John Maynard Keynes noted:

[Investing] is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.

What this means, as Minsky noted, is that avoiding the possibility of economic bubbles is really, really difficult (if not impossible by definition). Each stabiliser leaned upon to stabilise markets becomes another assumption lulling investors into assuming that this time is different and thus into riskier behaviours. Keynes and Minsky both recommended fiscal policy as the stabilisation lever, but fiscalism has become unfashionable and politically challenging.

Obama’s chosen mechanism for avoiding bubbles is decreasing income inequality. In fact he sees income inequality and economic bubbles as being intimately connected:

Even though our businesses are creating new jobs and have broken record profits, nearly all the income gains of the past 10 years have continued to flow to the top 1 percent. The average CEO has gotten a raise of nearly 40 percent since 2009. The average American earns less than he or she did in 1999. … This growing inequality not just of result, inequality of opportunity – this growing inequality is not just morally wrong, it’s bad economics.

Because when middle-class families have less to spend, guess what, businesses have fewer consumers. When wealth concentrates at the very top, it can inflate unstable bubbles that threaten the economy. When the rungs on the ladder of opportunity grow farther and farther apart, it undermines the very essence of America – that idea that if you work hard you can make it here.

It’s not sustainable to have an economy where the incomes of the top 1 percent has skyrocketed while the typical working household has seen their incomes decline by nearly $2,000. That’s just not a sustainable model for long-term prosperity.

This is all true. But it’s also all rhetoric. In his nearly five years in office, Obama has totally failed to get income inequality under control. According to Pew Research, since Obama came to office:

Mean net worth of households in the upper 7% of the wealth distribution rose by an estimated 28%, while the mean net worth of households in the lower 93% dropped by 4%

Research from the Bank of England shows that the main transmission mechanism used by central banks — specifically, reinflating asset prices — disproportionately favours the richest in society; those who already have assets whose prices can be lifted. The policies that Obama and Bernanke have pursued for the past 5 years have been tilted toward assisting the wealthy. The recovery has been a recovery from and for the top, while the poor have continued to experience greater social fragmentation, weakened social programs, and long-term unemployment. This has all been cemented by Obama’s own policies.

So while avoiding asset bubbles and reducing income inequality are laudable goals it is highly questionable that Obama — who has embraced an austerity agenda — will come close to achieving either.

UPDATE: Miles Kimball on Twitter points me toward Anat Admati’s suggestion of implementing bank capital requirements to make bubbles less damaging. This is a very fair suggestion, because it is a stabiliser that does not lean on the idea of eliminating bubbles, but the idea of limiting their impact. Obviously, rules can be gamed, but if implemented properly it could systematically limit the size of bubbles, by cutting off the fuel of leverage.

On Policy Uncertainty…

Paul Krugman says that the notion that the weak economy is due to policy uncertainty has been thoroughly debunked. The Stanford/Chicago uncertainty index has considerably fallen:

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Without any considerable boost to job growth:

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While policy uncertainty is concerned with policy in general, and not executive policy in particular, Krugman’s analysis is that “policy uncertainty” is a thinly-veiled attempt to blame Obama for the sluggishness of the recovery:

One of the remarkable things about the ongoing economic crisis is the endless search for explanations of something that’s actually quite simple — the sluggish pace of recovery. You have a large overhang of private debt; you have a still-depressed housing sector; and you have contractionary fiscal policy. Add to this the well-established fact that recovery tends to be slow after recessions caused not by tight money but by private-sector overreach, and there’s just no mystery that needs explaining.

Yet we’ve seen an endless series of analyses declaring that there is indeed a deep mystery, and it must be Obama’s Fault. Probably the most influential of these analyses was the claim that Obama was creating “uncertainty”, and this was holding everything back.

This crude notion of policy uncertainty is often attached to the notion of the Confidence Fairy; the idea that by running large deficits, government is crowding out private investment due to fears of future tax increases. The corollary of the Confidence Fairy view is that the only way to bring back private investment is to have large-scale austerity, to solidify expectations of lower future taxes. This view has been the basis for David Cameron’s economic policy in the UK, which can only be soberly judged as a large-scale failure.

Krugman is right to trash the Confidence Fairy — austerity at this point in the business cycle is a catastrophic error, because it sucks money out of the real economy. And he’s also right to trash those who view the sluggishness of the recovery as solely Obama’s fault. But he’s wrong, I think, to throw policy uncertainty out of the window entirely as a proximate cause of some of the problem’s we’re now facing.

Broadly, policy uncertainty goes both ways. That is simply because not all entrepreneurs in the private sector are looking for or worrying about tax cuts. People are heterogeneous. While there are some entrepreneurs worried about the future trajectory of taxes, many other entrepreneurs may be hoping for fiscal stimulus either because they would expect to receive orders from the government (for example, construction firms, defence contractors, universities, energy companies) or because they would be hoping that with stimulus, more people would have money in their pockets and they would be spending it.

While this, of course, cannot explain the crisis itself, nor the long and slow deleveraging since, having a deadlocked Congress erring on the side of austerity could be a major headache for many private enterprises. The fact that the more severe austerity experienced in Europe and Britain has actually led to bigger budget deficits there could result in even deeper and greater uncertainty for businesses. Put more simply, many businessmen could be reading Paul Krugman and others like him, agreeing with their interpretations, and worrying about the confused and deadlocked approach that the Federal government has taken to the post-2007 economy, and the dangers of austerity. This could contribute to the uptick in policy uncertainty measured by the Stanford/Chicago Index experienced since 2007 just as much as Wall Street Journal-reading Republicans worrying about the Confidence Fairy and taxes.

Paying For Our Past Sins

Michael Kinsley’s argument for immediate austerity is about “paying for our past sins”:

Krugman also is on to something when he talks about paying a price for past sins. I don’t think suffering is good, but I do believe that we have to pay a price for past sins, and the longer we put it off, the higher the price will be. And future sufferers are not necessarily different people than the past and present sinners. That’s too easy. Sure let’s raise taxes on the rich. But that’s not going to solve the problem. The problem is the great, deluded middle class—subsidized by government and coddled by politicians. In other words, they are you and me. If you make less than $250,000 a year, Obama has assured us, you are officially entitled to feel put-upon and resentful. And to be immune from further imposition.

Austerians don’t get off on other people’s suffering. They, for the most part, honestly believe that theirs is the quickest way through the suffering. They may be right or they may be wrong. When Krugman says he’s only worried about “premature” fiscal discipline, it becomes largely a question of emphasis anyway. But the austerians deserve credit: They at least are talking about the spinach, while the Krugmanites are only talking about dessert.

To Kinsley, austerity is the necessary spinach. I don’t really understand this. In the United States a crisis in shadow finance spread into the banking industry leading to a default cascade throughout the financial system, which resulted in a wider crisis throughout the economy, and ever since 2008 even after the banking sector was propped-up, unemployment throughout the wider economy has been rife, economic output has fallen far below its long-term trend line, and bank deposits are soaring as the weak economy has damaged confidence and convinced possessors of money to save and not spend or invest.

So many activities in the boom — from home speculation, to NINJA loans, to subprime securitisation, and ultimately the 40-year cycle of total credit growth that led to the Minsky Moment in 2008 — proved unsustainable. But a huge cost has already been paid for those unsustainable activities in the form of the initial crash, and depressed growth, and unemployment, etc. The structure of production has been irrevocably changed by the bust. But are the people suffering the unemployment, the depressed real wage growth, etc, the people who created the total debt growth? No, of course not. Any connection is arbitrary — the people creating the credit default swaps and structured securitised products (ABS, MBS, etc) and NINJA loans that triggered the banking crises in many cases have kept their jobs and been promoted. Certainly, some bankers like Dick Fuld who were involved in creating the crisis lost their jobs, but while people who had nothing whatever to do with the banking crisis have lost their jobs or worse have never even got a job.

So who does Kinsley want to consume the spinach? The people who take the hit to their purchasing power in an austerity program aren’t the ones who caused the financial crisis. Perhaps financial regulators and central bankers were to some degree responsible, but the overwhelming majority of people dependent on government income had nothing whatever to do with financial regulation. Though certainly one side-effect of the crisis has been falling tax revenues, which has meant bigger deficits. But structural deficits are actually relatively low, and nominal deficits are rapidly falling. And the actual interest rate cost of servicing the deficits are at record lows and with current soaring savings levels, unlikely to start rising anytime soon. So any appearance of a deficit problem is a side-effect of a depressed economy. Ultimately, austerity will reduce the government’s use of resources — capital, and labour. And what is the problem with the economy at the moment? Slack resources in capital and labour to such an extent that interest rates are at record lows and unemployment is very high. Kinsley’s “spinach” has nothing whatever to do with the problem. In the long run, once the economy is at full-employment and businesses are booming, and interest rates have risen some austerity will be helpful, not least to take the edge off the boom. But why now? Immediate austerity is iatrogenic medicine — misidentifying the problem, and prescribing a cure that harms the patient.

In my view a bust after an economic boom may be to some degree be unavoidable as an artefact of human psychology. Ultimately, we should remember that a credit-driven boom isn’t a sign of overproduction of goods and services, or a society living beyond its means. After all, the demand for goods and services really existed, and the capacity for the production and use of goods and services really existed. Humans are excitable animals, prone to strange twinges  of spirit both in mania and depression. The business cycle delivers the dessert and the spinach in recurrent cycles. Actions have consequences, and the actions leading into the slump have had huge consequences. But what about our present sins? Having the government force more spinach onto a society already suffering from massive unemployment of people, resources and capital is a strange and cruel prescription. We have already had our spinach in the crash of 2008 and the following slump. Huge numbers of people are unemployed, or have dropped out of the labour force, or have not had the chance to enter the labour force. That is the spinach. If the economy was a man, spinach would be coming out of his ears. Michael Kinsley and his intellectual cousins want to offset spinach with more spinach. Yet the economy has much the same or higher pre-slump capacity for ice cream, and pizza and milkshakes and marshmallows. In the long run, society will rediscover its taste for economic growth, for income growth, and all the slack resources will be used up to produce things that people actually want and need. Yet that does not help the unemployed who have eaten plateful after plateful of spinach as a consequence of actions for which they were mostly not responsible. What could help the unemployed? Job creation and putting slack resources to use.

Of Reinhart & Rogoff & the Emperor’s New Clothes

The brutal smashing that Reinhart and Rogoff’s work has taken in the past 24 hours, was inevitable even without the catalogue of serious methodological errors in their paper.

Reinhart and Rogoff’s empirical result posited a clear threshold. Reinhart and Rogoff were clear that  debt-to-GDP ratio above 90% spelled doom for growth. The actual data is far less clear:

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There is some correlation, but that correlation was loose enough to suggest that this was just one factor of many, and it never said anything at all about whether high debt caused low growth, or low growth caused high debt, or whether some exogenous factor was causing both. The real questions are all about causation.

Far from being a magical no-growth threshold, the UK experienced some of its strongest growth at a public debt level above 90% of GDP, suggesting very strongly that there are many other factors in play. In general, I would tend to caution against the use of arbitrary thresholds to establish principles in economics, whether that is the debt level necessary to lower growth, or the leverage level necessary to trigger a bank run, etc. The evidence suggests these almost certainly vary on a case-by-case basis.

Of course, much of the pro-austerity case seems to have been built on Reinhart and Rogoff.

Olli Rehn of the European Commission defended austerity as follows:

[I]t is widely acknowledged, based on serious research, that when public debt levels rise about 90% they tend to have a negative economic dynamism, which translates into low growth for many years.

Paul Ryan defended austerity using the same criteria:

Economists who have studied sovereign debt tell us that letting total debt rise above 90 percent of GDP creates a drag on economic growth and intensifies the risk of a debt-fueled economic crisis.

Timothy Geithner too:

It’s an excellent study, although in some ways what you’ve summarized understates the risks.

Lord Lamont of Lerwick (an adviser to David Cameron) agreed:

[W]e would soon get to a situation in which a debt-to-GDP ratio would be 100%. As economists such as Reinhart and Rogoff have argued, that is the level at which the overall stock of debt becomes dangerous for the long-term growth of an economy. They would argue that that is why Japan has had such a bad time for such a long period. If deficits really solved long-term economic growth, Japan would not have been stranded in the situation in which it has been for such a long time.

Doug Holtz-Eakin, Chairman of the American Action Forum:

The debt hurts the economy already. The canonical work of Carmen Reinhart and Kenneth Rogoff and its successors carry a clear message: countries that have gross government debt in excess of 90% of Gross Domestic Product (GDP) are in the debt danger zone. Entering the zone means slower economic growth.

This all feels very much like a case of the Emperor’s New Clothes. Those shining robes that cloaked the austerian case for austerity now and at-all-costs were based on serious methodological errors — as opposed to more nuanced criteria for fiscal consolidation during the boomtime, when interest rates on government debt exceed the unemployment rate. All those serious people who praised Reinhart and Rogoff’s seriousness clearly didn’t read it very well, or study the underlying data. Much more like they formed an opinion on the necessity of austerity now, and looked around for whatever evidence they could find for their preconception, whether Reinhart and Rogoff, or Alessina and Ardagna.

The fact that Reinhart and Rogoff did not, and are still not prepared to issue some clarification to their study to prevent its abuse by austerity-obsessed policymakers is sad given the copious evidence that austerity under present conditions is self-defeating. The fact that their response has so far consisted of defending their very weak conclusions — in full knowledge of the political implications of their work, and how it has been used to justify harsh austerity in very slack economic conditions — is very sad indeed.

When Is Austerity Necessary At The Treasury?

I have made clear in the past that I believe that the time for austerity at the Treasury is the boom, not the slump.

However this is a very general and non-specific definition. I want to be a little clearer and more specific.

First, I think it is important to define austerity. Government is a two-way street. It sucks in money through taxation, and it pushes out money into incomes through spending. Net government spending is the net of these two figures. Austerity in a technical sense happens when the change in net government spending turns negative either through spending cuts, or through tax hikes, or a combination of the two.

Second, I think it is important to specify that this is not a debate about the ideal size of government. This is a debate about the short-term government spending and taxation trajectory, which is a very different subject to one’s ideal size of government. It is possible to favour very small government in principle, but at times oppose austerity. It is also possible to favour large and expansive government, and at times support austerity.

Now, to be very clear: the time for austerity at the treasury is the time when government activity is crowding out the private sector. When does this occur? Well, the clearest example that I can think of are World War I and World War II. It is easy to imagine how government can smother the private sector in times of war; resources are centrally controlled and directed to the war effort, labour and capital are directed away from productive activities and toward fighting, toward building bombs and weapons to destroy things. There is little slack in the economy, as in total war the state commandeers as much of society as it possibly can toward the war effort. Notably, austerity programs that massively reduced the size of government following the two world wars were successful, and did not have a long-term downward impact on growth.

In peacetime, it is also possible for the government to crowd the private sector out of the economy, in a similar way. By commandeering large quantities of resources, labour and capital, governments can leave little for the private sector to use to create, build and invent.

The two most important parameters to determine whether a government is crowding out the private sector are labour markets and capital markets. In the broadest sense, the specific parameters are interest rates and the unemployment level. When the private sector is being crowded out in labour markets, unemployment falls to a low level, as the government is utilising all the slack. When the private sector is being crowded out in capital markets, interest rates rise to a high level, as the government is utilising all the slack.

Today, both in Britain and the United States unemployment is elevated (meaning labour is freely and readily available) and interest rates are very low (meaning capital is freely and readily available). First, Britain:

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Second, the United States:

USAusterityParameters

What this means is that in a technical sense — and irrespective of one’s preconceived notions of the ideal size of government — government is not crowding out the private sector. There is plenty of slack in the economy in both labour and capital markets.

Yet in another sense — unrelated to spending — governments may be slowing private activity. By imposing high legal and regulatory barriers to entry, governments can slow business investment and prevent new businesses from forming, and the unemployed from becoming self-employed. Given the massive growth of legal and regulatory burdens in certain industries favouring only large and old competitors who can hire lots and lots of expensive lawyers, it is extremely likely the case that there are some negative effects. The OECD noted in 2006 that “administrative simplification and reducing administrative burdens are a very high priority for OECD member countries”, and red tape levels have grown in both sides of the Atlantic since then. I have repeatedly suggested that in the current economic environment governments ease the regulatory and legal burden for small and new businesses in particular to foster competition and lower unemployment.

However cutting back on red tape is a totally separate matter to fiscal austerity, which in the current environment by definition takes an economy with significant capital and labour slack, and creates even more slack.

The time for fiscal austerity at the treasury is a time of high or rising interest rates and low or falling unemployment, and especially when interest rates are higher than the unemployment rate. The reality is that most of the Western world has the opposite of that right now.

As Soon As The First Nation Leaves, A Trickle Will Turn To A Cascade…

If enacting a levy on Cypriot depositors was a call for a bank run, then saying that the actions in Cyprus are a “template” for future recapitalisations in other Eurozone countries — as the Dutch Euro Group President Jeroen Djisselbloem did yesterday —  was screaming it from the rooftops awash in a demented stupour, drunk on bullshitty Smets-Wouters DSGE and the ridiculous notion that the Euro is sustainable.

Dijsselbloem

This question, I think, needs answering:

Dijsselbloem is yet to respond to the question, other than to say that his claim that it was a “template” did not in fact mean that he meant that it was a template. 

Tyler Durden jokes that the only conceivable reason for this could be an insane pseudo-Keynesian conspiracy to trick people and businesses holding cash to go out and spend or invest it, thus raising aggregate demand and generating recovery:

Last week, when we commented on the absolutely idiotic Eurogroup proposal (now voted down and replaced by an equally idiotic “bank resolution” proposal which will see uninsured deposits virtually wiped out) to tax uninsured and insured deposits, we jokingly suggested that this may be merely the latest ploy by the legacy status quo to achieve one simple thing: force depositors across the continent (and soon, world) to pull their money out of a malevolent, hostile banking system and push that money into stocks, or simply to spend it.

Given the utter folly of the levy itself and the subsequent comments, this might as well be as good an explanation as any. The easiest and quickest way to destroy the fractional financial system is to convince depositors around Europe or the world that their deposits are under threat. The European policy elite has displayed a slavish tendency to protect bondholders from losses, but not depositors upon whom the banking system is utterly dependent. If bondholders do not buy bonds, then it becomes harder for governments to finance themselves (although it must be noted that around the world, interest rates are at all-time-lows in every developed country with its own currency, suggesting a run on bonds by bond vigilantes is a relatively small possibility). But if depositors withdraw their money en mass, the banking system collapses.

I believe that this slavish devotion to preventing losses is fundamentally unhealthy, as capitalism without the potential for loss is robbed of any internal stabilisation mechanism. If bondholders or depositors cannot lose their money, they have no incentive to be prudent with it. But with the danger of a Eurozone bank run looming putting bondholders ahead of depositors is unhealthier still. Protecting government borrowing at the expense of confidence in the banking system is a dire error.

And it is not like there is really a hard choice between the interests of bondholders and depositors. If the European policy elite would deal with the huge social upheaval that the Euro system has created — namely, very high unemployment, youth unemployment and slack resources following the burst housing bubble in the periphery — then both depositors and bondholders could sleep easier at night. All this would take is a firm, long-term commitment from domestic and supernational governments to lending, tax incentives and spending to support business growth. A Europe that is growing, producing additional goods, services, energy and resources that people want and need will be far more stable than one that is shrinking and weakened (in both supply and demand) by forced and centrally-planned fiscal consolidation imposed by the policy elite. People want jobs, contrary to the assumptions of certain neoclassical economists who believe that all unemployment is voluntary. People want business, not to be subject to humiliation and subjugation to meet an arbitrary debt target set by delusional central planners actively weakening economic activity. And, the only way for peripheral nations to get this is through leaving the Euro, which may very well soon start to happen. And once it does, a trickle will turn to a cascade as the leavers begin to quickly recover from their Merkel-inflicted wounds.

In the long run, 25% unemployment in Spain and Greece (as well as elevated unemployment throughout the periphery) will come back to hurt the core, whether that is through weak demand for core-produced goods and services, social unrest, Eurozone-rupture, etc. And Dijsellbloem may yet see how foolish his template was.

Why Europe Is Still In Peril, In Two Charts

A lot of analysts, including myself, have given the European situation a rest since last year. There were certainly some signs that the ECB and IMF had slowed (if not stopped) the deterioration by providing liquidity backstops to the addled banking system. But perhaps that was just the calm before the storm.

In truth, things were still was probably just as perilous as ever up until yesterday when the ECB and IMF decided to start a banking panic by enforcing a haircut of up to 10% on bank depositors. That was literally the stupidest thing that anyone has done since the Euro crisis began, and while it may not lead to utter disaster, there is a significant chance that it will. Not only is it excruciatingly unjust (it’s theft!), it is also incredibly suicidal. Many, many Spaniards, Italians, Greeks and Portuguese will have looked at the Cyprus haircut in horror, and wondered “Am I next?” Some of those will withdraw their money from the bank and stuff it in a mattress or into tangible assets, furthering stressing the already-fragile and highly-leveraged European banking system. Even a 1% drop in European deposits would lead to over €100 billion of withdrawals.

The background to this is soaring European unemployment:

EuroUnemployment

The people running the European financial system and engineering the bailouts and austerity (ECB, EU, IMF, Germany) have ploughed on through with more and deeper austerity even as European countries (other, of course, than Germany) have run up to higher and higher unemployment levels. Spain and Greece are above 25%. Italy is above 10%, and Portugal above 15%. Hiking taxes and cutting spending is leading to more and more people in unemployment oblivion. That isn’t healthy. Let’s not forget what happened to Germany the last time when over 25% of its people found themselves unemployed:

Chart-German-Unemployment-and-Nazi-Links

If bank runs materialise across Europe next week, the unemployment situation is most likely to worsen even further. If that happens, expect more and more unemployed, underemployed and angry Europeans to start voting for increasingly radical political parties. This is suicidal. Europe needs to not only reverse the awful, stupid Cypriot haircut, but also to put fiscal consolidation on hold (it has, lest we forget, so far been counterproductive) and start worrying about unemployment levels.

George Osborne Still Doesn’t Get It

In downgrading British debt from AAA to AA1, Moody’s was explicit enough to mention weak growth as the main problem. Now, I couldn’t in itself care less about what Moody’s thinks, because credit ratings agencies are themselves bastions of utter incompetence who continued to rate subprime junk mortgage-backed securities as AAA long after it became clear that they were dangerous default-ridden products. But Osborne himself made clear that Britain’s credit rating was the metric on which we should judge his performance. Yet although Moody’s mentioned weak growth as the problem, Osborne continues to talk about how reducing Britain’s debt-load is his main priority, something that he has completely failed to do:

That ultimately is the choice for Britain — either we can abandon our efforts to deal with our debt problems and make a difficult situation very much worse or we can redouble our efforts to overcome our debts and make sure this country can earn its way in the world.

Osborne is tackling this from the wrong end of the problem. Strong, sustainable economic growth is the way to tackle the debt problem in the long run. But Osborne’s fiscal austerity is not the way to strong sustainable economic growth, which means he is failing by on his own terms and by his own definition. In terms of growth, since 2007 Britain has done worse than comparable countries.

realgdppercapita

People like to talk of Japan’s problems with depressed growth, but since 2007 Britain has done worse than Japan.

And this lack of growth is the real reason why Britain’s debt load becomes ever more unsustainable, no matter how much austerity Osborne tries to implement.

So what’s Osborne’s plan to generate growth? Reduce regulation and taxes on small businesses and new businesses? Make it easier for construction companies to build new homes? Invest in infrastructure (ultra-fast broadband, improved roads and rail) and energy (solar, wind, hydroelectric, oil, natural gas)? Invest in science and basic research? Guarantee loans to unemployed people so they can become self-employed? Offer incentives to foreigners to invest in the UK?

Cutting spending (and yes — in real terms George Osborne is cutting spending) and raising taxes isn’t cutting it. It’s constricting growth. And at the next election if this depression continues, people will vote in droves for anyone but Cameron and Osborne.