Wednesday, July 1, 2015

Perpetual Depression for the Sake of Growth

OK, I lied.  Again.  I know there isn't too much to do on the subject of Greece between now and Sunday other than watch and wait.  But there are so many related subject crying out for discussion that I sort of can't resist.  This time the subject of "structural reforms."

When you talk about the health and growth of a general economy, there are two sides of the equation, the demand side and the supply side.  Roughly speaking, the demand side is about how close to capacity an economy is operating.  Supply side is how fast that capacity can grow.  Traditional macroeconomics has been about the demand side.  How do we keep an economy from falling below its capacity.  I am not familiar with the "real business cycle theory" which attempts to explain business cycles from the supply side, but in general "structural reforms" are on the supply side, i.e., how things are produced and therefore how fast economic capacity can grow.  Traditionally, at least, they are considered part of micro.

"Structural reforms" also have a serious problem.  In almost all cases structural reforms mean ending job security, which tend to lead to layoffs and increase unemployment; reform means shutting down inefficient sections of the economy, which tends to increase unemployment; reform means getting rid of a lot of surplus work force, which tends to increase unemployment.  It also tends to mean cutting pensions (why pay people not to work?), weakening the safety net, and generally increasing the penalty for being unemployed at exactly the same time you are taking actions that will increase unemployment.  The goal here is that newer, more efficient, more competitive industries will rise to take the place of the old ones so the overall economy will grow.  (Greater "efficiency" tends to mean employing fewer people, and "more competitive" tends to mean paying less, but we can ignore that for now).

There is an obvious problem with these calls for supply side reforms.  All those people who have been laid off or had their pensions cut or made to feel the squeeze from being unemployed will respond by spending less.  This, in turn, will mean less business for remaining industry, unbought inventory, which will lead to fewer orders, less stuff being manufactured, and in turn, more layoffs and industries closing.  In other words, supply side reforms to improve the economy's capacity for growth can lead to reduced domestic consumption and thus a demand-side recession (or depression). The people calling for structural reforms tend not to see this as a serious problem.  More industry shutting down and more people being laid off just shows more aggressive structural reforms underway and are taken as proof of virtue.  If a country fails to rebound, it obviously just shows they didn't implement enough "structural reforms."  Nothing a few more shutdowns, layoffs, and spending cuts won't cure.  This is a lot of what is happening in Greece today.  It happened to Argentina at the turn of the millennium.  And to Europe in the 1930's.  And to Latin America in the 1980's.  And to Eastern Europe after the fall of Communism.  And to Asia in the 1990's.  And to peripheral Europe today.  But no one ever seems to learn from it.

Besides, the structural reform crowd usually disapproves of producing for domestic consumption anyhow.  Countries should produce for export.  (They tend also to disapprove of importing even as they encourage exports).

That opens at least one possibility as to how a country can get through supply-side domestic reforms without causing a demand-side depression.  It can allow its currency to fall and make up for the decline in domestic consumption by exporting more.  A falling currency will also give domestic industry a boost by making prices more competitive with imports.  This is not to say that a falling currency is painless.  It raises the prices of imports and inflates the value of foreign debts.  That latter is not a serious problem in a country like the US where most borrowing is domestic anyhow, but in a smaller country with a lot of cross-border borrowing, it can be ruinous.  These are unpleasant tradeoffs, but in general the best a country can do is either not peg its currency, or abandon the peg before it undertakes structural reforms.  The longer it delays a devaluation, the bigger the currency tumble will be when it occurs and the more traumatic the aftermath.  That, too, is what happened to Argentina, which had pegged its currency to the dollar and was unable to compensate by devaluation until the pressure became truly unbearable and the collapse catastrophic.  The recovery was rapid, but it would have been much better to have devalued in the first place and avoided the crisis.

That is precisely what Greece is now incapable of doing because it has not merely pegged its currency but given it up and therefore cannot devalue.

Another alternative if the country undergoing "structural reforms" is a debtor country (as it usually is) is to relax demands for austerity and allow the debtor country (Greece in this case, Argentina in another, also Latin America 1980's, Asia 1990's, southern Europe in general today, etc) to spend more of its income on domestic consumption and less on foreign debt service.  But there are obstacles there too.  First of all, creditors never seem to agree.  Second of all, keeping the squeeze on a debtor's economy is a great way of maintaining control.  Control to do what?  Why to force structural reforms, of course.  And what if those structural reforms continue to depress domestic demand and interfere with recovery?  So much the better.  It give greater leverage to demand more structural reforms.

At this point it become fair to ask what the purpose of all those structural reforms is supposed to be. It can't be entirely to get one's debts repaid, since the debtor country will never be able to repay its debts so long as its economy remains depressed.  So what is the purpose?  The usual answer is to improve economic health and allow for faster growth.  This is insane!  Keeping an economy perpetually depressed and crushed with debt in order to encourage faster growth makes about as much sense as invading another country to impose democracy at gunpoint.  (Another reason for my war analogy).

The usual objection is that you have to keep the pressure on to make structural reforms because if countries are instead allowed to experience a devaluation-fueled boom, they will neglect to make such reforms and their economies will end up in trouble anyway, as is happening to Argentina now.

And in the end, the answer has to be so what?  If a country is more interested in bringing its economy back to capacity right now than undertaking reforms that will allow its capacity to grow over the long run, but which also tend to shrink it farther and farther below capacity right now, is that such an unreasonable decision?  If a country breaks out of its immediate depression now, only to grow more slowly in the future, really who does it hurt but itself, and whose business is it but its own?

The analogy I often see given by austerity critics is that if a sedentary, morbidly obese patient has a heart attack, no one doubts that he should go on a diet and adopt an exercise program.  But an immediate starvation diet before he has had time to recover from the heart attack is a poor decision. And too strenuous exercise too soon can be fatal.  But really, a better analogy here might be a doctor deliberately keeping a patient sick so he will be more submissive to medical advice.  Advice about how to get well.  Think about it.

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