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.

Umaar Kazmi
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“They should be on bended knee apologising”: Chris Williamson warns Corbynsceptic Labour MPs

The MP for Derby North on his return to Parliament, why Labour won in marginal seats, and how party unity could have led to a Labour government.

At 5am on election morning, Chris Williamson was ceremonially tearing up some binbags. Two dustbin liners had been taped over the gold and green “Chris Williamson MP” sign on his Derby North constituency office since 2015. When it was announced that he’d won England’s most marginal constituency back from the Tories, he headed down to the old office with his team, and they tore the binbags down, dust raining upon them.

“Those black bin liners taped round were like a reminder whenever you glanced up that, one day, it’d be nice to pull that off,” he grins. In his two years away from the Commons, having been beaten by 41 votes last election, Williamson had been using the office as an advice centre.

Before then, the former bricklayer had represented the Midlands constituency from 2010 to 2015, having served as a local councillor – and twice as council leader – for two decades.


All photos: Umaar Kazmi​

Now he’s back, and squatting in a vegan-friendly café along the river from Parliament as he waits to be given an office. His signature flatcap sits on the table beside a glass of sparkling water.

“I’m not a fan of that place anyway, really, it’s horrible and oppressive, and not really fit for purpose,” he says. “That’s the slight downside. It goes with the territory I suppose. If we could move out of Westminster, that would be nice – somewhere like Birmingham or Manchester or Derby even – the centre of the country, isn’t it?”

“New Labour’s dead, buried and finished”

Perhaps this distaste for the bubble is to be expected, as Williamson is an ardent Corbynite. I followed him on the campaign trail before the election, and he was championing Jeremy Corbyn’s policies and leadership on every doorstep. It seemed a rather brave move among many undecided voters at the time, but has now been vindicated. You can almost tell from his trainers, crumpled polo shirt and contended expression that Williamson is supremely comfortable in the most left-wing Labour party since he became an MP.

“New Labour’s dead,” he says, his eyes twinkling. “No doubt about that. It’s dead, buried and finished. It's a regrettable chapter in our history. Historians will think ‘my God, what were they doing?!’” he cries.

Williamson believes he won due to Jeremy Corbyn’s character, the manifesto, a “fantastic” local campaign, and an “outstanding” national campaign. He thanks Momentum activists rallying so many people that they often had 20 teams canvassing simultaneously in his seat. And he praises an online campaign that targeted different demographics – Ukip voters in particular would mention his videos.

“If they’d been more supportive then we’d have got over the line”

“We targeted some elements of our campaign to specific cohorts,” he says. “For example, we did a message online to people who had supported Ukip previously about how a Labour government would genuinely take back control, take on the corporations, bring back the utilities into public ownership – rather than controlled by international, global corporations many of which are ripping us off.”

Williamson adds that young people were enthused by the pledges to scrap tuition fees, abolish zero-hours contracts and raise the minimum wage. He also saw Tory voters switch, attracted by a policy programme that he describes as “common sense” rather than radical.

He admits that people warned him to “disassociate yourself from Jeremy if you’re going to win” when he began campaigning. But he tells me he would “have sooner lost than gone down that road”.

But he has strong words for those who were more sceptical, saying they “let down their members” and lamenting that “if they’d been more supportive over the intervening period, then we’d have probably got over the line”.

Williamson calls on all the Corbynsceptic MPs to apologise: “They should be down on their bended knees and apologising, in fact. Not just to Jeremy but to the entire Labour movement.”

However, he believes his party is “more united” now than it has been for the 41 years he’s been a member, and is happy to “move on” – expressing his gratitude for how much warmth he’s received from his MP colleagues, “given how critical I’ve been of them!”

It may be Chris Williamson’s time in the sun – or the “sunshine of socialism” as he puts it, quoting Keir Hardie – but he does have jitters about his majority. It is 2,015 – the digits matching the election year when he was defeated by the Tories. “It’s a reminder that we lost then!” he laughs.

> Now read Anoosh on the campaign trail in Derby North with Chris Williamson

Anoosh Chakelian is senior writer at the New Statesman.

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