Was austerity an insurance policy?

Some very reasonable voices have argued that fiscal tightening post-financial crisis was a prudent form of insurance. According to this line of reasoning, although financial markets were treating the bonds of countries outside of the Eurozone differently, this might not have been the case. For example Tony Yates, in reply to this from Simon Wren-Lewis, says,

“I do think in broad terms the initial drive to austerity was warranted. [Though this is enough to embrace either the path the Coalition chose, or the one that Labour were proposing at the 2010 election].

…

At that time, there was a real sense that our own banking system could have been engulfed by a second financial crisis, and that this would have stretched our sovereign’s ability to pay. Simon has pointed out, persuasively, that spreads on UK debt were not blowing up at the time, and so this casts doubt on those worries. That said, there’s lots about measured market views about things that is puzzling, all the time. For instance, I find it perplexing [though I haven’t to my knowledge been joined in this view] that markets believed the ‘do whatever it takes’ promise behind the ECB’s OMTs [Outright Monetary Transactions]. Which to my mind seem nothing more than a successful bluff. It’s also worth pointing out that just as there can be bad self-fulfilling prophecies in sovereign markets, there can also be good ones. Just perhaps this explains the apparent success of the ECB and the UK case too. I’d also note that markets don’t know everything. There’s a lot that the BoE/PRA know/knew about the state of bank finances and exposures that markets don’t/didn’t.”

Ok. There is often lots about financial markets that is puzzling. But we can be a lot more specific and clearer about what was going on in bond markets from mid-2009 onwards. And none of it was particularly puzzling. More importantly, the evidence overwhelmingly suggests the opposite of what Tony is suggesting: austerity was a very high risk policy response, QE was the guarantor of sovereign safety.

Firstly, the sovereign crisis in the Eurozone really started after the ECB publicly rejected QE, in June 2009, as I have documented in detail. It is easy to forget, but at this point, it was by no means taken for granted that the ECB would not do QE, after all, everyone else was. Also, no one even thought there may be legal obstacles. Article 123 governing the ECB’s activities, which draws the distinction between primary and secondary market purchases, was known only to legal policy nerds. The rejection of QE by the ECB caused the sovereign crisis.

Now, the market’s reaction was coherent and logical. In a deflationary shock, credit risk rises throughout the economy, and if the central bank does not stand behind the government and the government cannot print money there is credit risk in the sovereign. That is watertight logic, and precisely how markets were behaving and continued to behave. Moreover, the market response to austerity in the Eurozone was equally logical and damning: it increases credit risk. Once Greece, Ireland, Portugal and Spain announced packages of aggressive austerity their sovereign spreads continued to widen. Why? Because falling output increases credit risk: revenues collapse, transfer payments rise, political risk rises, and private sector liabilities become contingent liabilities of the state.

This pattern was very clear. We do not have to restrict our sample to the UK and Europe, these patterns of correlation were evident everywhere: all developed government bond markets in countries which could print money were behaving in the same way regardless of fiscal dynamics. As the Eurozone crisis intensified and expectations of global growth and inflation fell, bonds rallied – everywhere, except in the Eurozone. Consider Japan which emerged from 2009 with a greater level of public sector debt than Greece and was running a huge primary deficit, which continues to this day. Japanese bonds were rallying during the Eurocrisis. Moreover, what did Japanese bonds do in response to the Fukushima disaster in early 2011, which caused a fall in output which Japan responded to by increasing its deficit? Yields fell to even lower levels. Why? Because there is no inflation and the Bank of Japan, in extremis can buy all the bonds – as we have seen.

Now Tony rightly points out that having the power to print money does not eliminate inflation risk premia in government bond markets. Of course not. But that’s the whole point. The opposite was happening: deflation risk was rising. Why else was the Bank of England doing QE? The Eurocrisis, coming straight after the global financial crisis, was threatening global deflation. (Tony, to be fair, had a different view of the inflation risks, specifically in the UK, at the time. But that does not square with monetary policy decision-making).

To make matters worse, the official analysis that government debt in the UK was rising dramatically is accounting nonsense. It relies on the assumption that base money is a debt, which makes little sense. The government is the monopoly supplier of reserves to the banking sector. After a financial crisis of the magnitude of 2008 a structural increase in demand for reserves by the private sector is inevitable, and, moreover, forced upon it by the regulator. This is a fiscal free lunch: reserves were being supplied by the government by buying back its own debt. Reserves are not a liability of the government – at worst they mask a contingent liability. Either way, a significant structural increase in reserves was rightly viewed as near-permanent, which implies that the government debt purchased by the Bank of England was, in practical terms, cancelled.

So these are the facts which prevailed ahead of the UK embarking on austerity:

1) The global economy and the UK faced the threat of deflation.

2) There was no evidence of sovereign credit risk outside the Eurozone, in fact the opposite was true: bonds were rallying everywhere else.

3) The Bank of England was doing QE: a clear signal that it sees major downside risk to inflation, and in practical terms QE involves the reduction in the stock of government debt – large enough in scale to offset the increase in debt caused by the financial crisis.

4) The few examples of aggressive austerity in the Eurozone were proving to be acts of suicide not salvation – for very good reasons: absent the ability to print money, austerity can increase credit risk.

The profoundest irony is that the only reason the UK could pursue its pseudo-austerity, without causing a market panic, is because it was not Greece. The UK government doesn’t have a debt problem, and it never did.