How austerity was based on market panic

Markets were full of fear. When that receded, so did the bond spreads.

When countries across Europe were putting together austerity policies in 2011, the orthodox reasoning was that the debt and deficit of the nations were out of control, and that this was being communicated by the markets, in the form of bond yields.

But did nations actually base their estimates of the need for austerity on the fiscal fundamentals? Or were they misled by market reaction? A research paper from Paul De Grauwe and Yuemei Ji breaks down the question.

It's certainly the case that the austerity was based, almost entirely, on the state of the market. The authors compare the extent of austerity measures in 2011 with the spreads of the nations' bonds (the difference between each country’s 10-year government bond rate and the German 10-year government bond rate), and find a near-perfect correlation:

Austerity measures and spreads in 2011

The authors write:

There can be little doubt. Financial markets exerted different degrees of pressure on countries. By raising the spreads they forced some countries to engage in severe austerity programs. Other countries did not experience increases in spreads and as a result did not feel much urge to apply the austerity medicine.

Now, that in itself is not particularly problematic. After all, if the financial markets are rationally responding to problems in the respective nations' finances, then it makes sense to try and calm them by getting finances under control. But if the markets are instead in the throes of irrational panic, then basing policy around their whims is problematic.

Ji and de Grauwe then come up with two proxies to test what it actually was which was driving the financial markets. If the markets are acting rationally, then as fundamentals improve, the spreads should fall. So, starting in mid-2012, they compare the change in debt-to-GDP ratio (just one possible measure of fiscal health) to the change in spread values.

They find that, over the period they're examining, debt-to-GDP ratio increases in every one of the ten nations they study. Despite this, however, the spreads decrease in each — and those decreases aren't particularly correlated with the debt-to-GDP change:

 

Change in debt-to-GDP ratio vs. spreads since 2012Q2

The bond markets don't appear to pay much attention to the basic financial health of the nations. What they do pay attention to is the European Central Bank. The paper states that:

The decision by the ECB in 2012 to commit itself to unlimited support of the government bond markets was a game changer in the Eurozone. It had dramatic effects. By taking away the intense existential fears that the collapse of the Eurozone was imminent the ECB’s lender of last resort commitment pacified government bond markets and led to a strong decline in the spreads of the Eurozone countries.

In the summer of 2012, the ECB removed fear from the equation. What happened then was a widespread collapse in bond spreads. But the collapse wasn't uniform; instead, "countries whose spread had climbed the most prior to the ECB announcement experienced the strongest decline in their spreads". By taking away panic, the ECB lets us see that almost all of the prior variation in the bond spreads had been as a result of that panic.

Basing policy on calm sensible market reactions might work; basing it on the reaction of markets in existential fear probably wouldn't. That's traditionally the time when politicians start trying to lead markets, rather than follow them. And, sure enough, the authors repeat a calculation confirmed by many others: panic-driven austerity has crushed growth in the nations it's been practiced…

Austerity and GDP growth 2011-2012

…and has hurt fiscal fundamentals in those same nations, with debt-to-GDP ratios getting worse the more austerity is practiced:

 

Austerity and increases in debt-to-GDP ratios

The TUC's Duncan Weldon (whose tweets first pointed me to the research) sums up the lessons we've learned:

  1. Financial markets are perfectly capable of acting irrationally. Market panic drove extreme austerity in Southern Europe.
  2. Extreme austerity has proved self-defeating – it means debt/GDP ratios are higher not lower.
  3. Markets, to quote the IMF’s Chief Economist, can be ‘schizophrenic’ – they initially reward harsh austerity measures and then panic when they, predictably, lead to weaker growth.
  4. The end result is that market panic, followed by policy-maker panic, has imposed huge economic and social costs across Europe

Seems like if politicians really really want to base their decisions on the ill-thought-out panic of large numbers of people, they ought to at least wait for an election.

Gambling with out future. Photograph: Getty Images

Alex Hern is a technology reporter for the Guardian. He was formerly staff writer at the New Statesman. You should follow Alex on Twitter.

Photo: Getty
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The future of the Left is London

Far from debating it and arid pamphlets, local politicians in City Hall and across the country are bringing change today, says Fiona Twycross. 

Broadly, London is viewed as a left-wing city. This is an assumption backed up by polling. That same city, however, has twice voted in Boris Johnson defying tribalism and defining a new order in which politicians will be defined less by the colour of their rosette and more by their pragmatism and how they make you feel about the world.

With the concepts of left and right as inaccessible and irrelevant as ever to most members of the public, the future of political ideas will be understood and judged by voters less by their ideological purity and more by their actions and effectiveness. On a recent canvass session on a housing estate in Outer London, it was a change to the bus route not Trident the people I spoke to wanted to discuss.

The future of the left – and of the Labour Party – isn’t something that will be shaped in the future. The future of the left is being shaped now. It is being shaped wherever those of us who define ourselves as left of centre are using whatever power we have to directly or indirectly effect change. In Labour run town halls, in Select Committees, through carefully worded press releases – however, we can. Limited by the budgets and rules laid out by central government – with the Tories in Westminster, politics is a game in which the dice are loaded against the left but in which we can sometimes win a round.

At the London Assembly, we have played a part in shaping the direction. We have won the occasional round. London Assembly Members have proven that shaping the debate is not only reserved for those who wield power. The banning of water cannon, the promotion of universal free school meals, the Government’s climb-down over devastating cuts to the police budget and not least exposing the Mayor’s vast record of vanity projects. As the largest party in City Hall, Labour has achieved sometimes small but often fundamental victories against Boris Johnson. Victories that have allowed the public to better understand the alternative we could provide as politicians who stand with their communities and protect the services they rely upon.

City Hall offers a challenging yet pragmatic forum to shape policies. With just 25 members in total, and no party having a majority, you really have to be able to work together to get anything done. The electoral make-up of the Assembly, including groups from minority parties as well as the two main parties requires a much higher degree of pragmatism, collaboration and in the end compromise than Parliament. As a result, policy - particularly that coming out of City Hall’s scrutiny committees - often commands cross-party support and a certain degree of legitimacy that political point scoring rarely achieves.

However, while we can change things round the edges; highlight injustices and propose alternatives that may sometimes be adopted, we must never lose sight of the fact that you can do immeasurably more if you are in power. Winning power to enact positive change, should be the guiding aim of any centre left politician.

With the next general election still likely to be more than four years off, the first major electoral challenge since 2015 comes in the shape of this May’s elections in local councils across the country, in devolved countries and in London.

The upcoming Mayoral election means throwing off the abstract and painting an image for Londoners of what a left wing alternative in London would look like. That picture will resonate far beyond London - the future of the left really is being shaped today.

That is exactly what we are doing and what Sadiq Khan is offering. Standing up for hard pressed Londoners who are increasingly forced into poverty or priced out of the capital altogether.

From building affordable homes to tackling London’s air quality. From freezing fares to protecting neighbourhood policing. All of these are policies with mass appeal but at the same time, all are ones which disproportionately benefit the least well off in our society. The left, if anything has to stand for a fairness.

But voters don't want just abstract vision, they want tangible change. Sadiq Khan is putting forward ambitious, progressive policies for London, but to implement them as Mayor, with the Conservatives in power nationally, he will have to not just argue with government but make the arguments for London to get the best deal he can. 

With high levels of child poverty in Conservative run boroughs like Westminster and Kensington & Chelsea, he knows he can’t afford only to be able to work with Labour boroughs if he wants all young Londoners to have better life chances. What matters isn’t just what works it is working with all those you need to build and deliver change.

From City bankers to environmentalists, a Labour Mayor will need a range of allies. In charting his own course, having his own voice and putting London and Londoners at the heart of his policies. What works for London won't necessarily work everywhere, that will mean a necessary element of independence, that's not disloyal, its the job. 

Whether in London or beyond, the left needs a message relevant to people like those I met on that housing estate in outer London. Authenticity and independence matter. In a world where tribal politics has broken down ensuring you don’t look like you put your party before the people you represent matters. But you can do this and still stay true to your values.

Our opponents like to paint a horror story image of what the country would look like under Labour. A win in London offers the chance to dispel that myth and will show the success to be had with a Labour politician who is willing to govern in the interests of the majority rather than just the few.

A win in London will show the progressive left has a future, here and now. A future that delivers.