Default vs Austerity

Last week I asked:

So will America continue to tread the bone-ridden road of austerity, high taxation and crushing economic contraction, leading to excessive money-printing, and ending in the death of the dollar and an inflationary firestorm? Or will it choose the sustainable route of default, low taxes, a return to productive, organic growth, and the opportunity to decrease reliance on foreign energy and goods?

Today I present a case study in austerity (Latvia) vs default (Iceland). And I think it’s clear which is the path that clears the way for new growth and prosperity.

Here’s GDP:

And here’s unemployment:

Iceland is a shining example of a nation willing to shun the narrow interests of creditors in the name of its people’s prosperity.

Austerity (the bankers get their pound of flesh) is a nonsense path to misery — it is rather like expecting a heroin addict to go cold turkey. If your patient is hooked on government intervention and handouts, withdrawing those handouts will lead to riots, and just as significantly, a crushing contraction in both confidence and GDP. Getting junkies off their fix of government intervention requires organic growth and prosperity — hard to achieve in an economy strangled by excessive levels of public debt, and high taxation to pay interest on that debt.

The free market alternative to austerity is default — all lending, even lending to “Quadruple A” debtors — has risks, and the chief risk is that the debtor can’t afford to pay its debts. And if the debtor can’t afford to pay the debt, then either the debt should be renegotiated, or tough nuts. The people of the nation who have come (for better or worse) to depend on government services shouldn’t suffer for the malinvestment of bond traders and foreign creditors. Should the time come, it is the bond traders and creditors who must take a haircut.

37 thoughts on “Default vs Austerity

  1. Would you still be so definitiv if instead of using Latvia you had used Ireland in your analysis ?
    As usually, interesting article.

    • I’ve added another graph to the article on unemployment that also features Ireland. Of course, the key case is Argentina, which defaulted and has since embarked on almost a decade of staggering new growth and prosperity.

      Also — here’s what Irish GDP did over the same time period:

      They had a worse 2009, but a better 2010 in real GDP terms (so fairly similar), but have done much worse than Iceland in unemployment terms.

  2. Some problems with your arguments: Iceland is no bigger than a moderate city (~300,000 population) – this can be problematic when you go on to compare it with the US.

    And second of all, Iceland’s economy was mostly healthy BUT was encumbered by the blow-up of the banks. You can’t say the same thing for Greece where the average railway worker gets ~5000 EUR. This can’t go on. Even after a default, they won’t find money to keep those wages at those levels.

    A return to the drachma, would covertly crush the wages as well. So anything they do, they’ll get austerity.

    Another thing: as I’ve argued in another comment, the US is currently not encumbered by high taxation and the creditors are still very lenient. So they’re definitely not in the situation of Greece. So if the US wants to grow and it can’t, at least for now, this can’t be attributed to their debts.

    • If I was to compare the US to anyone, I’d compare it to Argentina (very salient comparison for historical reasons), as I have done before.

      The US is very fortunate that its creditors are relatively lenient, seeing as it is materially dependent on them in maintaining the status quo (oil economy & consumerism). In fact it is my view that this leniency will shortly be coming to a juddering halt, with nasty consequences. But it’s not just public debt and taxation that can be the problem — it’s anything that prevents saving and investment and that includes consumer debt as well. That debt will all ultimately have to be erased, either by repayment (growth-killing), by inflation (risky) or by something else (debt jubilee, eventual currency devaluation). Of course there are other factors that are preventing saving and investment — over-reliance on consumption being the one that immediately springs to mind — but it is hard to argue that over-indebtedness (public and private) is not a significant factor.

      In any case, Greece:

      Greece with the drachma could easily keep salaries at the same nominal level: by printing money. The purchasing power of the drachma would fall, but the key is that the new inflation would erase a significant chunk of public and private debt, making future growth easier (lower debt burden means it is easier in future to save and invest). Austerity deflates, making the debt an even bigger burden, and making future growth more difficult.

      • True, it’s mostly the private indebtedness that’s preventing the US from growing. But that’s what I was saying, the creditors are still very lenient and want to give the US time to deleverage. So that’s what I meant that at least at this stage, defaulting on the public debt doesn’t make much sense (at least not until it gets to be a burden).

        In the case of Greece – as far as I know they don’t have a private indebtedness problem, it’s only the public debt. And going back to the drachma would be nothing more than covert austerity (which might be more palatable for the population – they won’t be able to attribute it to the Troika).

      • I meant “austerity” as a sharp drop in the living standards – and this is what Greece will get after they start printing – at least in the short term; how long will this drop lasts, no one can know (and comparing this to other countries should be taken with a grain of salt).

        • I don’t think anyone here will deny that Greece (and most of Europe) are heading for lower living standards in the short to medium term.

          But in the modern sense, austerity means when a government cuts nominal (and absolute) spending to lower deficits.

      • I think that it’s the gain in competitiveness that ultimately matters for a country that wants to grow. Greece currently lack competitiveness. To increase competitiveness, they can do it through inflation or forced cuts in wages. Inflation is IMF’s recipe probably simply because it’s the more palatable way given that it’s covert. In Greece, forced cuts don’t appear to be the way to go (riots, violence). Here in Romania, they cut public wages by 25% overnight in 2010 and pensions by 15% and soon after that we got growth (which will probably by annihilated by a possible global double dip recession). Note that Romania is for all intents and purposes in the EMU – almost everything you buy is priced in EUR and the central bank here keeps the exchange rate in a tight range (though they’re not officially committed to this).

  3. Aziz,

    I really liked your past couple/five articles. Really top notch stuff.

    But, I feel here, your missing a point on Argentina. Yes, their GDP has grown, but this is do mostly to inflation, not organic growth.

    A guy by the name of ferfal ( does a very good job describing the aftermath of the 2001 debt default.

    While I agree that default is the best path for everybody, do not think that default leads directly to prosperity. Living standards of a country that defaults go down (obviously), but the default whould allow households and businesses to again form capital, the government to shrink its burdensome bureaucracy and the economy to recover onto a sustainable path.

    It is this sustainable economic path that allows living standards to rise. Argentina is most definitely NOT on a sustainable path!

    PS Didn’t Argentina just relect President Cristina Fernandez? Ay-ya-ya.

    • I agree it’s not a direct path from default to prosperity — in fact it’s a pretty messy path. But eventually something will break the debt burden, and better default than hyperinflation or currency collapse.

      I am willing to keep an open mind on Argentina, and I will do more reading via ferfal. It’s not my specialty and yes Kirchner’s government have been involved in some pretty wacko shenanigans to under-report inflation. The real GDP figures are supposed to be adjusted for inflation, of course. But whatever the true GDP/inflation picture, figures from the World Bank do strongly suggest that there has been a real improvement. Poverty rates in Argentina have significantly dropped in the last decade, from over 35% before the crisis, to just 15% now:

      The key to sustainability in my eyes is energy, resource and food independence. A nation can manage high inflation if it is independent in these three sectors. Argentina is relatively independent in this regard, deriving most of her electricity from her own natural gas and domestic hydroelectric, and maintaining relatively friendly relations with Venezuela, the South American oil superpower.

      However I am open-minded to other perspectives.

      Please feel free to post more info relating to Argentina.

      • I also agree that restructuring is always preferable to the chaos of hyperinflation. But this is not a path that should be tread on lightly. Austerity does have its place – otherwise you’d just default on every penny of any debt you ever owe – and most of the time the fault for the debt lies both with the creditor and the debtor (sometimes more with the former sometimes more with the latter).

        Default/restructuring should naturally come about as the best solution for both parties – i.e. when considering future growth prospects post default, loss to the creditors by extending maturities etc.

        Again, what I wanted to stress in my above comments is that this is heady stuff that should not be taken lightly. While the debt may forever suffocate a country, when talking of default we should always keep in mind that there’s a moral side to the story – i.e. the debtor did enjoy/spent the lent money.

        • The problem is that the people of a nation who suffer from austerity are not the same people who spent/received the money — the greatest benefit goes to the corporate elite and military-industrial complex, and the people whose services get cut are the common taxpayer (“defence” is usually ring-fenced). The responsibility ultimately lies with the creditor — you lend money to a deadbeat, (even a deadbeat with access to a printing press) and he can’t repay it, then that’s your fault for not doing due diligence. The common taxpayer, the disabled man who cannot work, and those on unemployment benefits should not suffer for the malinvestment of lenders, and government takeovers by the military-industrial complex.

          Nations who keep their house in good order can afford to repay debt without austerity — but irresponsible ones cannot. The point is that lenders should be forced to make lending to irresponsible nations more difficult, so nations think twice before acquiring ridiculous quantities of debt pursuing countless wars and bailouts.

      • PS: I hope I made some sense above and that you can get over the rather “woolly” definition for “austerity” that I employ (I’m rather busy and don’t have time to be fully eloquent in each post I make on a blog).

      • “The problem is that the people of a nation who suffer from austerity are not the same people who spent/received the money — the greatest benefit goes to the corporate elite and military-industrial complex, and the people whose services get cut are the common taxpayer”

        This is again only partially correct and will differ from nation to nation; this is why I’m arguing for what’s fair and not for debt repayment at all costs. See my previous comment about the complexity of the whole system.

  4. Economists and ordinary citizens alike have been trained to accept that GDP growth is the definative measure prosperity and its not.

    A simple example of the way folks confuse GDP growth with prosperity is the US GDP growth between 1998-2008. In 1998, US GDP(approx.) = $8 Trillion. In 2008 US GDP(approx.) = $14 Trillion. So in ten years, US GDP grew by approx 75%.

    Now here is the rub using GDP growth. That 75% does not represent an increase in organic growth. I.E., the American citizens do not have 75% more house or 75% more cars or 75% more jewlery….etc.

    That 75% growth represents financial growth as measured in dollars. This is the trick of inflation. When measured in dollars, a six-pack of beer that cost say $4.99 in 1998 and then that same six pack of beer costs say $6.99 in 2008 would add 60% per six pack to the GDP in dollars. But, of course nothing has changed about about beer over that 10 year period. The six pack still only gives you 72 oz. of beer.

    Ahh, the wonders of inflation.

    PS I will get back to you Argentina, but I highly encourage you check ferfal’s blog.

  5. Aziz,

    I should preface the below with the following: I agree with you that Argentina has many natural resources that once tapped, can and will help raise the living standards of the Argentines. – short clip regarding the % of poverty in Argentina. – contemporary history of currency devaluation in Argentina (kind of convoluted, but it gets the point across.) (ferfal’s posts on the topic of inflation. I beleive he is an architect by training which gives a refreshing look at economics by someone who has yet to be brain washed by the modern economic establishment.)​americas/06argentina.html – another article on the inflation problem in Argentina.;_ylt=A2KJkewHv6VOTR4AGtyJzbkF;_ylu=X3oDMTBlMTQ4cGxyBHNlYwNzcgRzbGsDaW1n? – chart of the gold price in Argentine pesos.

  6. Andrei Canciu, I agree with you. The Debtor spent the money. The right thing is to repay.

    Obtaining entry to the EU via deceit and lies is not a good start to a “Noble” project.

    Obtaining a wage (Pension at 50, or well paid Government jobs) through Government cronyism and apathy about who pays the bill is bad morals, doomed to fail.

    The only choice is for the interest on the loans to be peeled back to inflation plus a reasonable return, and the principal repaid; slowly. Usury’s rates do no country any good.

    It is like spoiling a child then punishing them for their bad morals.

    • In a free market economy responsibility ultimately falls to the lender: you uncautiously lend money to a bad debtor who can never repay, you suffer the consequences of default.

      The problem with the other solutions (austerity and inflation) is that the wider population (who may have benefited from the money, but never authorised the lending) suffers the consequences of the state’s inability to repay its debt.

      “Debt-repayment at all costs” is just another example of market rigging a la “too big to fail”.

      • In a free market, the lenders will also have the possibility to extract whatever they can get from a bankrupt entity.

        Finally, it’s not about debt-repayment at all costs – I think it’s about doing what’s fair for everyone (as I’ve made that clear in one of my above comments) – the blame can be equally put on both parties (sometimes more on the lender, sometimes more on the debtor).

        “but never authorised the lending) suffers the consequences of the state’s inability to repay its debt” – this is only partially correct. True, the system is too complex to put any blame on anyone in particular, but on the other hand, they did vote for those politicians and there were always voices pointing the obvious.

        And most of the time, default goes hand in hand with inflation (this has always been IMF’s recipe); why? Because those holes that can’t be plugged with more debt must be plugged with devalued money. Default with no austerity and no inflation would be a rare bird indeed.

        I can’t help but notice that your arguments would be in favor of the EMU as it currently is IF it were not for the intractable interconnectedness of the banking system. The Germans are fighting hard to protect the value of the Euro while pushing for a PIIGS default. This would work just fine if it were not for the impossibility of this (due to a total banking system collapse).

        • In a free market, the lenders will also have the possibility to extract whatever they can get from a bankrupt entity.

          That’s why I favour renegotiation over pure default — they get paid (eventually).

          This would work just fine if it were not for the impossibility of this (due to a total banking system collapse).

          Yes — there we have the problem — the market is presently rigged to make defaults impossible so everything (or almost everything) has to be bailed out. The eventual goal is to create a marketplace and banking system where money is not debt-based so that there can be defaults and large-scale failures without a severe credit contraction and default cascade.

          And most of the time, default goes hand in hand with inflation (this has always been IMF’s recipe); why? Because those holes that can’t be plugged with more debt must be plugged with devalued money. Default with no austerity and no inflation would be a rare bird indeed.

          I’d argue that in fact inflation is more prevalent with non-defaulters. Let’s be clear about this: austerity, even if implemented (painfully) can achieve only a little in terms of debt repayment. As has been shown by numerous studies, tax revenues tend to drop even further during austerity, making it even harder for the debt to be repaid.

          The real choice is between open default, and hidden default (by debasement). And as we have established, default by debasement is a messy, messy process that negatively affects anyone who comes into contact with the nation’s currency.

        • All that proves is that trying to inflate your way out of debt (by anything less than hyperinflation) doesn’t really work.

          In fact that chart makes a great case for suggesting that for most problematic debtors, traditional Debt:GDP reduction strategies are really quite impotent:

          High inflation or low inflation, the debt is likely to continue to climb, as governments appease creditors as they roll their debt.

          The choices seem to be hyperinflation ( a messy kind of default), negotiated default, and large-scale organic growth.

          Absent large-scale organic growth, I know which one I’d pick.

      • Yes, I know about hyperinflation – I just thought you believed in the myth of covert default through moderate inflation (which for some reason UK appears to be succeeding in doing 😛 probably because no one is looking at them right now).

        But then again, I stick to my previous points: I can’t see a default without austerity and/or high-inflation (there may be exceptional cases however). Why? Because the flow of money-debt is interrupted – the holes that were previously being plugged by it will have to be plugged with devalued money – OR the holes will have to be eliminated.

        So the bottom line is: great dislocations in the society will have to occur either before the default or after default. This was my whole point in this argument: the solution can’t simply be default. It must be default + something else. And you’d better start making these changes before you default – either way, you can’t avoid pain (there might be exceptional cases again, but I’m talking about the baseline scenario).

        • There will be pain — the entire Western economic free lunch setup since 1971 guaranteed it. I don’t want to understate just how much pain is going to be meted out — my entire angle since I started writing was that the entire Western system is ripe for collapse. My point is that negotiated public default would — for most citizens — reduce the taxation burden (and therefore pain) during this tumultuous period of drastic change. Things are already bleak enough — austerity will end up making things bleaker, at least in the short-to-medium term.

          Do I expect to see the kind of public default I am advocating before the shit hits the fan? No — I expect to see more borrowing to roll debt and fund phoney stimulus packages for the elite (Solyndra), while the poor and middle get the austerity.

      • Yes, I generally agree with your above comment. But the right thing for US to do right now would be to focus on clearing up the zombie economy and not entertain thoughts of default. My guess is that Ron Paul was pushing for a default a few months ago because he knew that there are only slight chances for the US to do the right thing (and the right thing IMO is bleaker things in the short-to-medium term). He might have been right:

        • Thanks for the Bonner article.

          Solon did exactly what I advocate — debt cancellation. The problem really is that in my view, the high levels of residual debt are what is causing the zombification — without the residual debt, banks and corporations can fail without dragging down the system. Without the debt, the bailouts can stop.

          That Gideon Rachmann quote is very interesting — the U.S. needs to learn that a diminished global role (especially in terms of defence spending) is not necessarily a bad thing in terms of standards of living and national security.

      • Yes, but after debt cancellation they did this: “After Solon sorted out their debt problems, they were soon back in the empire business and back in debt.” Which is again connected in many ways to the points I was trying to make here (that we can’t speak of default in isolation, i.e. “only” default as a solution).

        • You have read my writings enough to know that I do not advocate debt default/jubilee in isolation as a solution — clearing out the debt does offer a lot in the way of defragilising the market, but the two biggest factors I talk about are cutting military spending and corporate welfare and re-directing this capital to more productive endeavours.

  7. I agree wholeheartedly. Imagine if your bank went running to the government to make you take out another loan at a higher interest rate when you default on your mortgage! My brother used to offer me loans to avoid bankruptcy in Monopoly so he could win by an even bigger margin (yes, so I could be even more broke).

    Austerity is what you do before you go broke, not after it. Banks are willing to make money on loans, but outsource the risk. To hell with them. They got to make a fortune in the interim, so no sympathy from me.

  8. Pingback: The Biggest Bubble in History « azizonomics

  9. Pingback: The End of European Sovereignty? « azizonomics

  10. Pingback: The End of European Sovereignty? « azizonomics

  11. Pingback: Deleveraging? « azizonomics

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s