-- Posted Thursday, 11 July 2013 | | Disqus
By Daniel R. Amerman, CFA
A confidential internal International Monetary Fund report was recently leaked to the Wall Street Journal, with the contents later being made public by the IMF. The contents of this report have major implications for Europe, but even greater implications for the United States.
Most of the press attention is being paid to the legalities associated with the report, and revolve around what the International Monetary Fund knew, when it knew it, and whether it properly acted within its charter at various points. However, what is being overlooked is the truly explosive information that comes in the form of what the IMF admitted (in this internal report to itself) when it came to miscalculations about "austerity", and closing budget deficits.
Briefly, the International Monetary Fund and European Union did not force balanced budgets upon Greece, but only a reduction in the level of deficits.
The IMF's economists estimated that this reduction in deficits would lead to a 5.5% reduction in the size of the Greek economy. But they were horrified to discover that in practice they were dead wrong, as it instead resulted in a 17% contraction in the Greek economy, or just over three times the damage that they were estimating.
They were also badly mistaken, as they belatedly came to realize, when it came to the impact of these deficit cuts on the official unemployment rate.
That is, the IMF had expected unemployment to rise to 15%, which was unpleasant, but a necessary part of the belt-tightening associated with austerity and reducing the levels of government deficit. In practice, however, unemployment jumped to 25%, a level grossly in excess of IMF estimates, and which also placed the entire economic theory underlying the austerity approach in jeopardy.
For the decrease in tax revenues associated with a 17% contraction in the economy, combined with an official unemployment rate of 25%, is of such magnitude that the government deficit reduction targets can no longer be met.
A loop was created in which the economic damage associated with reducing government spending - even while increasing tax rates - was so great that it offset the enhanced revenues expected from this combined "austerity" strategy.
The issue is what economists refer to as the fiscal multiplier– and this is what the IMF so badly underestimated. What they failed to fully take into account is that when all those beneficiaries of government spending lost their income - whether they be government employees, private contractors or transfer beneficiaries - they would stop spending their income.
So when the corporations, and municipalities, and waiters, and cooks, and convenience store employees whose jobs were dependent on that spending saw a contraction in their own revenues, they spent less as well. Which led to reduced employment, and a further reduced economy that spiraled down in a multiplier effect, causing the Greek economy to contract three times more than expected, even as unemployment levels grew to a level that was almost twice as high as expected.
Bigger Problems In The United States
Greece is not the only nation that has what could be called an "artificial" economy, if we define an artificial economy as being one where both economic output and employment levels are each materially dependent on the government borrowing money that it can't possibly pay back under normal circumstances.
And arguably the globe's largest "artificial" economy is also the globe's largest economy – which is that of the United States of America.
As I have previously covered in detail in a series of articles which includes, "The Economic Deception At The Heart Of The Fiscal Cliff", linked below, the economic situation in the United States is in fact much worse than what can be seen at the surface level of government statistics and the financial media's reporting thereof.
And this can be established quite easily by going directly to the government's own statistics themselves, and looking underneath the headline statistics, to the next level below.
The government share of the United States economy has been growing for many decades now, fundamentally transforming the country as a result. And by 2007, the United States economy had reached the extraordinary point (outside of a major war) where the government was consuming a full 35% of the economy. That is, government spending amounted to 35% of the economy, and 65% was the private sector.
Then something remarkable happened. At the height of the Financial Crisis of 2008, the private economy imploded by $1.3 trillion per year when it came to the real private production of goods and services. This was a catastrophic decline that if left untouched, would have pushed the United States straight into an overt Depression.
But this implosion, while confirmed in the government's own statistics and very real, is not what the government's surface level reporting of GDP shows at all. Instead, what the official statistics indicate on that top level is that there was "only" a $300 billion contraction in the economy, with the recession officially having ended in June 2009.
Wait, what? How could it be that if the private sector within the economy plummeted by $1.3 trillion, that the total economy only fell by $300 billion?
Well, when it comes to desperate governments in a time of economic collapse, there turns out to be a bit of a loophole. And that is that when GDP is reported by the media, what is reported is almost always total GDP - which is the sum of economic activity by the private sector and the public sector. So in looking only at total GDP then, any catastrophic declines in private economic activity can be effectively masked by equally extraordinary increases in public spending - at least temporarily.
That obscure little loophole is the hidden-but-real story behind 2009, and every year since. In practice, the difference between the actual government-reported $1.3 trillion collapse in the private sector, and the officially reported $300 billion decline in the total economy, came from federal, state and local governments increasing their spending by a staggering $1 trillion between 2008 and 2009.
This resulted in a massive and unprecedented shift in spending as the government soared in size, even as simultaneously the private sector was collapsing in size. So the economy nearly instantly shifted from being 35% government and 65% private, to being 43% government and 57% private – a level which remains in approximate terms true today.
So when we look at these fantastic levels of deficits that have been consistently coming in at well over $1 trillion per year, what we have in fact been seeing is the increase in the size of the government from 35% to 43% of the overall economy, in order to maintain the facade of an intact economy.
In other words, since the fall of 2008, a substantial chunk of the US economy has been "artificial". The private-sector imploded. It has not recovered to this day. And the great majority of damage containment has been dependent on the United States government running unsustainable deficits, of which it lacks the ability to pay back under ordinary circumstances.
Dire Lessons For The US From Greece
Here are some questions that may be worth considering: what happens to economic output and employment if we were to unwind the crisis-averting "artificial" economy in the United States, and bring the ratio between private sector-created wealth and government spending back to pre-2009 levels, and thereby return deficits to sustainable levels?
What might the real price be of returning to "normal"? And can we get there at all in the near future?
The size of fiscal multipliers for government spending has been a highly controversial question within economics for many years now.
In previous articles, I chose to neutralize the fiscal multiplier controversy by taking the analytically conservative approach of assuming the fiscal multiplier to be 1.0. So if we reduced government spending as a percentage of the economy to a pre-2008 level, then we would see exactly proportionate reductions in the size of the economy, as well as proportionate increases in unemployment rates.
However, the dire lesson to take away from Greece is that if the United States government were in fact to abandon its "artificial" economy and return to spending no more than it could afford to pay, based upon tax revenues and a much reduced level of annual deficits to a more historical level, then a likely higher fiscal multiplier could translate to a change in the economy that is much more drastic than even that.
If the lessons of Greece do indeed apply to the US economy, then the unfortunate implications are that reducing government spending as a percentage of the economy to let's say 2007 levels might cause the economy to drop not by 5-6%, but by 8% to 10%. This would take the United States straight into an overt depression.
And unemployment could go from our current headline rate of 7.6% - with the real full unemployment rate (adjusting for U-6 unemployment and workforce participation rate changes) of roughly 19% - soaring up to a real full unemployment rate of 25-30% or more, which would be a higher level than during the Great Depression.
Now whether those numbers would actually occur - or whether they'd be something else altogether - would be a massive experiment, and nobody can really know at this point.
But what we do now know, based upon real-world data from this leaked IMF report on their experience with Greece, is that the consequences may be much worse than what even some of the leading economists in the world anticipated they might be, because the fiscal multiplier in practice has proven in these circumstances to be much higher than previously thought.
IMF Discovery & False Dichotomy
The second half of the article is linked below. As explored therein, when we consider the full implications of the interrelationship between the fiscal multiplier and the extraordinary current deficit levels - the mainstream version of the future simply doesn't add up. We can't stop and we also can't afford not to stop. But that doesn't mean that collapse is necessary, either.
Continue Reading The Article
Daniel R. Amerman, CFA
This article contains the ideas and opinions of the author. It is a conceptual exploration of financial and general economic principles. As with any financial discussion of the future, there cannot be any absolute certainty. What this article does not contain is specific investment, legal, tax or any other form of professional advice. If specific advice is needed, it should be sought from an appropriate professional. Any liability, responsibility or warranty for the results of the application of principles contained in the article, website, readings, videos, DVDs, books and related materials, either directly or indirectly, are expressly disclaimed by the author.
-- Posted Thursday, 11 July 2013 | Digg This Article | Source: GoldSeek.com