Wednesday, July 17, 2013

17/7/2013: Wrong Austerity Compounds the Failures of the Monetary Union


Recent CEPR paper DP9541 (July 2013), titled "Debt Crises and Risk Sharing: The Role of Markets versus Sovereigns" by Sebnem Kalemli-Ozcan, Emiliano Luttini, and Bent E Sørensen (linked here: www.cepr.org/pubs/dps/DP9541.asp) used "a variance decomposition of shocks to GDP", in order to "quantify the role of international factor income, international transfers, and saving in achieving risk sharing during the recent European crisis."

Basic idea of the exercise was that a lack of saving in good times may reduce consumption smoothing in bad times, forcing households to cut back their spending and consumption more dramatically once recession hits.

Under perfect risk sharing, the consumption growth of individual countries should be completely independent from all other factors, conditional on world consumption growth.

The authors of the study "calculate how much of a shock to GDP is absorbed by various components of saving, in particular government saving, and other channels, such as net foreign factor income for the sub-periods 1990-2007, 2008-2009, and 2010." The key finding here is that "overall, risk sharing in the EU was significantly higher during 2008-2009 than it was during the earlier period, but total risk sharing more or less collapsed in 2010." Notably, 2010 is the year when European economies embarked on 'austerity' path, primarily and predominantly expressed (especially in the earlier stages) in tax increases. It is worth noting that there virtually no reductions in public spending during 2009 or 2010 across the EU and even in countries where spending was cut, such as Ireland, much of the reductions came from indirect taxation - e.g. transfers of health spending from public purse to private insurance.

Further, the authors "study how the crisis a affected risk sharing for "PIIGS" countries (Portugal, Ireland, Italy, Greece, and Spain), which were at the center of the sovereign debt crisis, compared to non-PIIGS countries (Austria, Belgium, Denmark, Finland, France, Germany, the Netherlands, Sweden, and the United Kingdom)."

Again, the findings are revealing: "For 1990-2009, risk sharing was mainly due to pro-cyclical government saving but the amount of risk sharing from government saving turned negative in 2010 for the PIIGS countries: government saving increased at the same time as GDP decreased." In other words - this is the exact effect of austerity as practised by the EU periphery.

"For [euro area peripheral] countries our measure of overall risk sharing turns negative because (conditional on world consumption growth) the decline in GDP in 2010 was accompanied by a more than proportional decline in consumption. This mirrors the behavior of emerging economies where government saving typically is counter-cyclical as shown by Kaminsky, Reinhart, and V egh (2005)."

Crucially, the study shows that there is basically no risk-sharing mechanism that operates on the entire euro area level. Even common currency zone - via lower interest rates - does not deliver risk sharing in 2010 and has potentially a very weak effect in 2008-2009 period. Worse, for the euro area peripheral states, euro has been a mechanism that seemed to have removed risk sharing opportunities both in and out of the crisis:

"…although non-PIIGS countries shared a non-negligible amount of risk during 2000{2007 while the PIIGS shared little risk in those years: in the good year 2005, consumption increased faster than GDP leading to "negative risk sharing." In 2008 and 2009 the major amount of GDP risk is shared for non-PIIGS with low consumption growth rates in spite of large drops in GDP, with the amount of risk shared in 2008 over 100 percent (positive consumption growth in spite of negative GDP growth). For the PIIGS, consumption declined very little in 2008 in spite of a large drop in GDP, while the drop in GDP in 2009 clearly led to declining consumption and, in 2010, consumption fell by almost as much as GDP, indicating little risk sharing."

Top line conclusion: once the authors "decompose risk sharing from saving into contributions from government and private saving", data reveals "that fiscal austerity programs played an important role in hindering risk sharing during the sovereign debt crisis."

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