OECD Wrong on European Crisis

The Great Recession continues to baffle economists around the world. Some have actually admitted that their academic research has been wrong – kudos to the economists at IMF for leading the pack – while others continue to stumble around in the dark. A story in The Guardian gives an example of economists in the latter category:

A failure to spot the severity of the eurozone crisis and the impact of the meltdown of the global banking system led to consistent forecasting errors in recent years, the Organisation for Economic Co-operation and Development admitted on Tuesday. The Paris-based organisation said it repeatedly overestimated growth prospects for countries around the world between 2007 and 2012. The OECD revised down forecasts at the onset of the financial crisis, but by an insufficient degree, it said. “Forecasts were revised down consistently and very rapidly when the financial crisis erupted, but growth out-turns nonetheless still proved substantially weaker than had been projected,” it said in a paper exploring its forecasting record in recent years.

Technically they under-estimated the effects of the credit losses that financial institutions suffered, but not for the reasons the OECD believes. Their forecasting mistake is instead founded in a two-pronged misunderstanding of the true nature of the crisis. First, they fail to realize that this was a welfare-state crisis, created by a slow but relentless growth in the burden of government on Europe’s economies. The weight of the government’s fiscal obesity eventually became so heavy on taxpayers, and the disincentives toward work and investment so strong, that it did not take much to nudge the economy into a deep, severe crisis.

The welfare state’s role in the crisis was enhanced by the fact that in the years leading up to the crisis Europe’s banks bought a trillion euros worth of Treasury bonds, a good chunk of which was from countries that soon turned out to be junk-status borrowers. This seriously aggravated the balance sheets of banks that were already struggling with credit losses.

If they had not been forced to deal with the junkification of Greek, Spanish, Portuguese and Irish government bonds, the banks would have been able to manage and endure the private-sector credit losses. But the unlimited irresponsibility of spendoholic legislators escalated a recession into a crisis.

The second prong of the OECD’s forecasting mistake has to do with austerity. Humbly put, nobody outside of my office grasped the truly negative impact of austerity as early as I did; the only ones who have caught up are IMF economists. On the other hand, their analysis of the role of the multiplier has, frankly, been intriguing. Nevertheless, by not understanding that austerity is always negative for macroeconomic activity, the OECD has missed the forecasting mark even more than by just misunderstanding the relation between the welfare state and the financial sector.

All in all, there is still a lot to be said on what has happened in Europe these past few years, and what implications that has for the future of Europe as well as for America. I am impatiently looking forward to the July release date of my book Industrial Poverty which provides a thorough analysis of the crisis.

Interestingly, as we return to The Guardian, the OECD denies my point about austerity:

The OECD said a failure to understand the impact of austerity policies in various countries did not appear to be a major driver of forecasting inaccuracies. It said the OECD became better at factoring in the impact of austerity amid little space for further monetary loosening as the crisis continued. Overall, “fiscal consolidation is not significantly negatively related to the forecast errors”.

This is a blatant refutation of what the leading economists at the IMF concluded over a year ago. The IMF paper is compelling and based directly on observed forecasting errors. Their main point is that the multiplier effect of one dollar’s worth of government spending cuts is stronger than the multiplier of one dollar’s worth of government spending increases. They show good evidence for this conclusion, evidence that the OECD ignores entirely.

Furthermore, as I report in my forthcoming book there is a wide range of literature on austerity and its effects, and that literature has one thing in common: politicians always under-estimate either of two things: the negative effects of austerity, or the persistent problems with pulling out of a recession by means of austerity.

But there is yet another point where the OECD is wrong. If the financial-sector problems were to blame for the depth and the length of this recession, then why is it that the credit losses happened several years ago, that the bank bailouts have been essentially wrapped up and that, thanks in part to the European Central Bank’s easy monetary policy, there are no longer any credit worries in the European banking system – and Europe is still sinking into higher unemployment and more budget problems??

The underlying presumption in the OECD’s focus on the financial system is again that this was a financial crisis, nothing else. But if that was the case, we would have entered the crisis with sky high interest rates; the banking system would have signaled systemic credit defaults by drying up credit and raising interest rates to the sky before the macroeconomic downturn began. But none of that happened. Interest rates in Spain, Greece and other troubled EU member states started rising only after the recession had escalated into a crisis!

What does this tell us? To answer that question, let us take one more step into the technicalities of macroeconomics. The reason why interest rates went up was not that the financial sector raised the price of credit. The reason was that Treasury bonds in Europe’s big-government states were sent to the financial junk yard. The reason why the Greek government has had to pay ten times higher interest rates than, e.g., the Swiss government is that the Swiss government has never defaulted on its loans while the Greek government forced its creditors to write off part of their loans.

In short: when interest rates started rising in Europe, it was because of unimaginable budget deficits, i.e., a crisis in the welfare state, not the financial system.

One last weirdo from the OECD:

“The macroeconomic models available at the time of the crisis typically ignored the banking system and failed to allow for the possibility that bank capital shortages and credit rationing might impact on macroeconomic developments,” it said.

Credit rationing? At a time when the central bank has flooded every corner of the economy with liquidity?? Europe’s banks hold trillions of dollars in government bonds, and in theory they could go to the ECB and, under the ECB’s bond buyback guarantee, demand cash right now for them. That would be free money for the banks who could then lend it out to whoever they wanted to lend to, and almost be guaranteed to make good money.

In reality, the rationing is not on the supply side of the credit market. It is on the demand side where there are not enough credit-worthy households and businesses to gobble up Europe’s rapidly growing money supply. The fact that the OECD fails to see this adds to my conclusion that they have not done their homework on the Great Recession.

Again: this is a welfare-state crisis, not a financial crisis.