I was going to dicuss some of the goings on in Europe today but I noticed a question on another thread which I thought was important to addesss in the context of both Europe and Australia. I’ll come back to Europe next week as there is a bit to say on Italy’s fiscal slippage along with some other issues.
The question that got my attention was this one from Tarric in which he asked:
Is it possible that cutting the budget so substantially could potentially created a feedback loop of austerity much like in Europe?
To answer this I think we need to clear up exactly what we are seeing in Europe before we can answer that question in the context of Australia.
Firstly, in order to explain this properly, it is important to understand that wealth is not just money. Money, in the context of how most people would understand it, is currency and bank balances which intrinsically have no value yet are legally binding future claim on goods and services from others. Debt, is the obvious opposite, being legally binding claims of future goods and services from oneself.
So in that regard, the value of a nation’s money is a function of the perceived value of the goods and services that the nation’s people can provide others in the future. Wealth, however, is also the value of the assets that the private sector already has claim over, that is goods and services that have already been produced. Good examples being houses and equity.
The reason I explain this is because at the core of Tarric’s question is an understanding of the importance of private sector wealth and how it drives economic activity.
Spain is the current focus of the European crisis and provides a very good example of this. In the run up to the GFC Spain’s economy was driven by expanding credit towards housing. This led to indebtedness of the private sector, yet at the time their assets were accumulating value in excess of this debt. So for a period of time Spanish households were accumulating wealth but by doing so they were continually creating future claims on their own goods and services.
When the Spanish housing market collapsed so to did the value of their assets, while the debts remained. This placed the private sector in a position where it perceived that its net claims on future goods and services had significantly declined. Obviously under these circumstances the private sector desired to re-accumulate this claim in order to support its current and future standard of living.
However, given the falling asset prices, and therefore the perception of further loss of wealth in non-money assets, the desire of the private sector is to hold onto and attempt to accumulate money. This behaviour creates an environment in which there is less demand for good and services which slows economic activity and , ironically, inhibits the private sector’s ability to meet that desire.
This leads to the failing of austerity, because cutting government spending and raising taxes makes the private sector’s desire to accumulate money even more difficult. But focussing on this fact too much hides another important point.
As you can see from the example of Spain, wealth isn’t just about money. If it was then Zimbabwe would be the wealthiest country in the world. As I said above, money gets much of its value from the goods and services that the nation can produce that are perceived as “of value”. However, as Spain demonstrates well, in order to maintain value and therefore economic stability, these goods and services need to be delivered in a way that doesn’t lead to an ever growing claim on the private sector for their future goods and services. If it does then at some point a limit will be reached , and crisis will ensue.
And this is the crux of Tarric’s question. The government can remove money from the private sector via running a surplus budget but whether or not that leads to an economic slump is ultimately dependent on the private sector’s capacity to continue to gain wealth under these circumstances.
With the Australian private sector current in a phase of disleveraging, house prices are falling while debts continue to accumulate. Given that households hold a significant portion of their wealth in housing this is leading to a fall in household wealth. It is therefore possible that a drive for surplus by the government will create a self re-enforcing dynamic that leads to a further loss of wealth. It is for this reason that I support the notion that a push for surplus at this time is a gamble.
Importantly, however, it is not correct to automatically assume that the government can continually run a deficit and this will continue to create private sector wealth. The government does not directly create wealth by adding money into the system, as I said above, money intrinsically has no value aside from its inherent ability to extinguish obligations to the state. Simply adding new money into an economy will only lead to greater wealth accumulation if it somehow creates greater capacity to produce goods and services of value. If that capacity does not exist then it will drive inflation, that is, lower value of money relative to goods and services.
Ultimately for an economy to be sustainably successful requires it to have capacity to build wealth in a way that doesn’t require the continued accumulation of claims against future delivery. That is why, in the long run, innovation and productivity are key.
The Australian political class should have their eye on these two things, not its balance sheet.