Sunday, 7 March 2010

Something Has to Give

Something Has to Give

7th March 2010

The Malta Independent on Sunday

Alfred Mifsud

When pressure builds up, something has to give.

The financial crisis of 2007-2009, and the lingering recession that followed, put tremendous pressure on the fiscal position of most governments. Those that were already fiscally exposed through lax management when the going was good have been particularly hard hit.

It is obvious that the small and the weak are particularly vulnerable, though no one has really been spared – not even the US, even though it is the largest economy in the world and has the benefit of endowment as provider of the world’s main reserve currency. US unemployment crept up to 10 per cent, and if one adds those on involuntary part-time work, and those who slipped out of the workforce as they gave up on finding a job, the real unemployment level would be nearer 17 per cent. The fiscal deficit exploded to 12 per cent and the government, even in the mighty US, is scratching its head over how to reduce the deficit without crushing the nascent fragile recovery.

In the UK, the budget deficit is equally out of control and whoever gets elected this spring, irrespective of whether it is Brown, Cameron or a coalition government involving the Liberal Democrats, will have to bite the bullet and force some pretty drastic fiscal adjustments. These will be no walk in park.

Yet both the US and the UK have a safety valve that is denied to most of us on this side of the world. They are still in control of their sovereign currency and can shift, and indeed have shifted, a good part of the adjustment process on the rate of exchange. In fact, since the financial turmoil started in the summer of 2007, both the US dollar and the pound Sterling have fallen substantially against the euro.

Greece, Spain, Italy, Ireland and Portugal have no opportunity to shift any part of the necessary adjustment on the rate of exchange policy – and neither do we! Even if we could, micro states with open economies have very limited ability to use rate of exchange policy as a meaningful part of their adjustment solution, as the case of Iceland is clearly showing.

So within a monetary union, the adjustment has to be executed directly where it cannot be camouflaged by exchange rate optics. The adjustment has to be made where it is politically very sensitive: in the wage level through wage freezes, wage cuts, loss of benefits and extension of retirement age, apart from job losses generated by the recession. The adjustment has to involve increases in VAT and income tax rates and it will have to involve the removal of subsidies. In short, it is like forcing consumers through the sausage machine.

In some countries, people curse their politicians but understand that what needs to be done has to be done. They grind their teeth, bite the bullet and move on in the hope of better times in the not too distant future. In this category I would place Ireland, the Baltic countries, Hungary and some Balkan states. In other countries, particularly the Mediterranean members of the EU that suffered from governments that fed their electorates with illusions that debts and deficits do not matter, the electorate rebels and takes to the streets. The most obvious case is Greece.

The excesses of the past have now caught up with Greece and the weight of their external debt is crushing their economy. Reality avoidance has rendered their economy inefficient and uncompetitive and now they are being forced to take the strong medicine in one swoop. A government elected on a mandate to dish out more state goodies is being forced to serve up austerity. What the protests in the streets of Athens are about is not clear. Surely the Greek population at large understands that, after all, debts do matter and no other country can be expected to finance the Greeks so that they can go on pension earlier than the Germans, have more holidays than the French and pay less taxes than the Benelux countries.

Perhaps the protests are against their leaders, who cooked the books to create an unsustainable illusion of easy life, a fairy tale of paying the least taxes and receiving the maximum state benefits. If so, the protesters have every reason to take to the streets, as long as they realise that, ultimately, the medicine has to be taken, the sooner the better, and the pain has to be endured. Government’s responsibility in such dire circumstances is to ensure that the pain is distributed equitably and fairly and that, like it or not, it is time to tax consumption and promote investment.

Greece and others, however, cannot do it on their own. The adjustment cannot be extracted solely from oppressive fiscal measures. Economic growth has to be a key feature in the recovery plan. The problem is that fiscal oppression impacts negatively on economic growth. Domestic demand shrinks, as people lose income, pay more tax and get generally uncertain about their future. Growth can only be achieved through external demand but this can only grow very gradually, as the country recovers its competiveness.

It is here that the big rich countries in the euro area have to support Greece. The rules of the monetary union need to be re-jigged and an exit route for those countries that cannot live by the rules has to be created. The absence of a threat of being forced out of the euro has led to moral hazard, as undisciplined countries thought they could get away with lax fiscal management. Secondly, the euro rules have to include progressive sanctions for countries that register structural intra euro area payments imbalances, surplus as much as deficit.

The Germans should not play the high moral ground of fiscal prudence. They benefited from Greece’s indiscipline by enjoying structural balance of payments surpluses. The weakness that the Greek crisis inflicted on the euro exchange rate has benefited Germany much more than Greece as it is Germany that exports most to countries outside the eurozone, rather than Greece or its Mediterranean peers.

There is a strong moral obligation on the North European powerhouses to stimulate their economies to create demand and growth opportunities for Mediterranean economies, as they undergo compression of internal demand and painful fiscal adjustments.

Where does this leave our street protests about yet another hike in our utility bills? To the extent that such street demonstrations are meant to expose displeasure, then all is well and good. But street protests per se offer no solutions.

Solutions must come from government coming down from its high detachment from the feelings of the general population and using its leadership qualities (where are they hibernating?) to explain to us lesser mortals that some pain now can avoid much greater pain in the future, as the Greek experience is showing.

Government has to be much more sensitive with policies for utility rates. In the bad old Labour days, utility bills were cross-subsidised by profits from the petroleum division, ie the importation and distribution of fuel. Even though the latter has been liberalised, there is nothing to stop government from raising excise duties on fuel to cross subsidise utility bills, or at least to avoid sharp fluctuations in the latter.

The simple truth is that the price of fuel at the pumps is much less socially sensitive than utility bill rates. Fuel at the pump is paid in drips and drops that offer consumers a timely opportunity to adjust consumption patterns. Utility rates, on the other hand, come in one bullet shot, well after the consumption has occurred, offering scant opportunity for timely adjustment.

Furthermore, consumption of fuel at the pump offers much greater opportunities for consumer economies, such as switching to public transport, car-pooling and other measures that would greatly improve our environment and quality of life. Unfortunately, household utilities offer much lesser scope for economies, at least not without substantial investment in alternative sources that are beyond the reach of most of us.

No one is suggesting that government should feed us Greek illusions, but it can certainly afford to be more sensitive in its policies about pain distribution.

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