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.

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Politicians: it's no longer OK to know nothing about technology

It’s bad enough to joke about not being "techy"; it's worse to write a piece of legislation from a position of ignorance. 

Earlier this week, facing down a 600-strong battalion of London’s tech sector at a mayoral hustings in Stratford, Zac Goldsmith opened his five minute pitch with his characteristic charm. “I’m not very techy!” he exclaimed. “I understand coding about as well as Swahili!”

Pointless jibe at a foreign language aside, this was an ill-chosen way to begin his address - especially considering that the rest of his speech showed he was reasonably well-briefed on the problems facing the sector, and the solutions (including improving broadband speeds and devolving skills budgets) which could help.

But the offhand reference to his own ignorance, and the implication that it would be seen as attractive by this particular audience, implies that Goldsmith, and other politicians like him, haven’t moved on since the 90s. The comment seemed designed to say: “Oh, I don't know about that - I'll leave it to the geeks like you!"

This is bad enough from a mayoral hopeful.  But on the same day, the Intelligence and Security Committee of Parliament filed its report on the Draft Investigatory Powers Bill, the legislation drafted by the Home Office which will define how and how far the government and secret services can pry into our digital communications. Throughout, there's the sense that the ISC doesn't think the MPs behind the bill had a firm grasp on the issues at hand. Words like "inconsistent" and "lacking in clarity" pop up again and again. In one section, the authors note:

"While the issues under consideration are undoubtedly complex, we are nevertheless concerned that thus far the Government has missed the opportunity to provide the clarity and assurance which is badly needed."

The report joins criticism from other directions, including those raised by Internet Service Providers last year, that the bill's writers didn't appear to know much about digital communications at all, much less the issues surrounding encryption of personal messages.

One good example: the bill calls for the collection of "internet connection records", the digital equivalent of phone call records, which show the domains visited by internet users but not their content. But it turns out these records don't exist in this form: the bill actually invented both the phrase and the concept. As one provider commented at the time, anyone in favour of their collection "do not understand how the Internet works". 

Politicians have a long and colourful history of taking on topics - even ministerial posts - in fields they know little to nothing about. This, in itself, is a problem. But politicians themselves are often the people extolling importance of technology, especially to the British economy - which makes their own lack of knowledge particularly grating. No politician would feel comfortable admitting a lack of knowledge, on, say, economics. I can’t imagine Goldsmith guffawing "Oh, the deficit?  That's all Greek to me!"  over dinner with Cameron. 

The mayoral candidates on stage at the DebateTech hustings this week were eager to agree that tech is London’s fastest growing industry, but could do little more than bleat the words “tech hub” with fear in their eyes that someone might ask them what exactly that meant. (A notable exception was Green candidate Sian Berry, who has actually worked for a tech start-up.) It was telling that all were particularly keen on improving internet speeds -  probably because this is something they do have day-to-day engagement with. Just don't ask them how to go about doing it.

The existence of organisations like Tech London Advocates, the industry group which co-organised the hustings, is important, and can go some way towards educating the future mayor on the issues the industry faces. But the technology and information sectors have been responsible for 30 per cent of job growth in the capital since 2009 - we can't afford to have a mayor who blanches at the mention of code. 

If we’re to believe the politicians themselves, with all their talk of coding camps and skills incubators and teaching the elderly to email, we need a political sphere where boasting that you're not "techy" isn’t cool or funny - it’s just kind of embarrassing. 

Barbara Speed is a technology and digital culture writer at the New Statesman and a staff writer at CityMetric.