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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Britain cannot shirk its duty to defend Hong Kong from China's authoritarianism

Arrests of pro-democracy activists show China is breaching its commitments to the “one country, two systems” agreement.

When Chinese Foreign Ministry spokesman Lu Kang said in June that the Sino-British Joint Declaration no longer has any “practical significance”, shivers were sent down the spines of those who want democracy to flourish in Hong Kong.

“It is not at all binding for the central government's management over Hong Kong. The UK has no sovereignty, no power to rule and no power to supervise Hong Kong after the handover,” he said.

Going by the British government's failure to respond firmly to the jailing of Joshua Wong, Nathan Law and Alex Chow for standing up for democracy, it appears the UK agrees.

The Sino-British Joint Declaration, signed in 1984, was committed to the “one country, two systems” principle, making Hong Kong a Special Administrative Region of China but ensuring a range of freedoms, which future British governments would ensure were upheld.

China’s creeping influence over Hong Kong’s legal affairs and freedom of speech are not new. Earlier this year, Amnesty International said the human rights situation in Hong Kong was at its worst since the handover in 1997. That assessment followed the disappearance of five Hong Kong booksellers, later found to have been in the custody of the Chinese police, with one describing having been blindfolded and kept in a tiny cell. In other instances journalists have been attacked by police. 

But in Hong Kong, resistance is on display in familiar scenes on the streets. Tens of thousands of people have marched through the financial and legal hub in protest at the jailing of the three pro-democracy activists for their role in the Umbrella Revolution in 2014 – a fundamentally peaceful movement.

It was a moment where people came out to fight for universal suffrage, which I continue to support as key to safeguarding the island’s stability and prosperity (and something Hong Kong’s Basic Law secures by stating that the chief executive should be selected by “by universal suffrage upon nomination by a broadly representative nominating committee in accordance with democratic procedures”).

For showing courage in fighting for universal suffrage, Wong has already served 80 hours of community service and Law 120 hours. Chow received a three-week suspended prison sentence a year ago. Yet now Wong has been jailed for six months, Chow for seven months and Law for eight months.

Wong was even summoned again to court today for an ongoing contempt charge related to the 2014 "Occupy" pro-democracy protests.

Perhaps more importantly, Wong is now not eligible to stand for the legislative council for five years due to his six-month jail sentence, while Law, who was a member of the council, was removed from office.

This all comes after a 2016 order from Beijing for Hong Kong’s government to dismiss officials thought lacking in their allegiance to China, which led to six legislators being banned from holding office.

Many, including Hong Kong’s last Governor, Chris Patten, have suggested Wong, Law and Chow's sentences were a deliberate attempt to prevent them from taking on these legislative positions.

Patten added that he hopes friends of Hong Kong will speak out, having previously written the UK is “selling its honour” to secure trade deals with China, letting down pro-democracy activists who have been trying to fight to maintain freedoms that were guaranteed during the deal that ended over 100 years of British rule.

The prising open of the case by the Hong Kong government to push for tougher punishments reinforces concerns about Beijing’s willingness to interfere in Hong Kong’s democracy. As Amnesty International stated, seeking jail terms was a “vindictive attack” on freedom of expression.

China’s enthusiasm for subverting democracy has recently been on show in its attempts to censor Cambridge University Press (CUP), which initially complied with a Chinese request to block access to more than 300 articles from the China Quarterly, a leading China studies journal, including articles on Chairman Mao’s Cultural Revolution and the Tiananmen Square Massacre. Following public pressure CUP have now reversed their position.

But while freedoms granted under the Joint Declaration may have contributed to Hong Kong becoming fertile ground for those supportive of democracy and critical of China, it does not free the United Kingdom from its responsibility to uphold the “one country, two systems” principle, which promises extensive autonomy and freedoms to the island, except in the area of foreign relations and military defence.

Read more: The dream deferred by Chris Patten

The Joint Declaration is a legally binding treaty. It is registered with the UN and is still in force. As the UK is a co-signatory, it should be doing all it can to make sure it is upheld.

Yet, in late June one of Hong Kong’s most respected democracy activists Martin Lee described the British government as "just awful. I’m afraid I cannot find any kind words to say about that.”

It is not for either China or the UK to unilaterally decide the Joint Declaration is null and void. The people of Hong Kong understand that and are standing up for democracy in the face of adversity. Our Government has a duty to stand by them.

Catherine West is the Labour MP for Hornsey and Wood Green