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Sovereign Austerity Remains Key

By   /   June 25, 2012  /   No Comments

The forthcoming EU summit is being heralded as the latest crucial event in the ongoing Eurozone crisis, and Ms. Merkel is sticking to her line of fiscal austerity.

Unsurprisingly, markets are not hopeful. In some senses, nor should they be. One would be justified in going as far back as the initial shocks of 2008 to recognise that ever since then, sovereign debt levels were always going to manifest themselves in a negative manner at some point down the line. Whether those negative effects were going to simply emerge as higher bond yields, or would spiral into unsustainability and sovereign default, was, and for many Eurozone nations, still remains, uncertain. What should be certain is the continued need to reign in spending, and pursue austerity.

Minsky would be turning in his grave. The American economist devoted the majority of his professional life to the study of financial crises, and has been frequently cited by those in the media charged with the unpleasant mandate of analysing our current difficulties.

Minsky proposed that each business cycle contained three stages – the hedge, speculative and Ponzi stages. Initially, hedge borrowers, he argued, accurately appreciate the nature of their future earnings and build in realistic (risk-adjusted) growth models accordingly; be they pension funds, hedge funds, firms or individuals.

As competition for profits increase and agents become more ambitious in their search for Alpha, they enter the speculative stage, where they anticipate future profits, and rely on them for their current business plans. Such speculative actions might include relying on future profits to finance debt repayments on a loan needed to fund a capital investment project. Indeed, speculative finance can occasionally find a place in a successful business model.

Ponzi finance is another matter. As the name suggests, this reckless phase relies entirely on future profits to fund today’s transactions. Businesses begin to be run in a manner more befitting Bernie Madoff’s scheme, and are entirely unsustainable.

Unfortunately for Europe, such reckless and myopic money management was not limited simply to the banking sector and individual traders. European governments were engaging in speculative and Ponzi finance behaviour too.

To some extent, given the way our political system is structured, this need not come as a surprise. Indeed, some might argue that the very model of a nation-state is flawed in the sense that as nation-states compete with each other, attempting to produce goods at lower costs, striving to provide better healthcare and education, and trying to provide more favourable taxes and benefits for its citizens, they spend beyond their means in order to out-do each other, and in order to get re-elected. Most agree that such goals are worthwhile, the problem lies in the fact that they create an incentive for governments to borrow in the present, relying not just on future revenue, but future growth of revenue.

In this way, governments deprive future generations by cashing in future gains today, and paying ever more for the privilege of doing so in the form of rapidly-climbing bond yields. It is not just flawed economics, but morally questionable too. How can consistent budget deficits be justified when they burden every British newborn with around £20,000?

As citizens, we pay for public goods such as roads, healthcare and education in the form of taxes. Ideally, as a population, we should get out roughly what we put in, and we have a progressive tax system so that, in Mr. Cameron’s words, the “greatest burden is borne by the broadest shoulders.” To add an extra £20,000 to this figure so that today’s population can live beyond their means at the expense of future generations is morally indefensible.

Yes, our descendants will have more advanced technology at their disposal. They will receive more advanced healthcare, and better education, on the whole, than the current generation did. However, by burdening our grandchildren in this manner, we are retarding the speed of this development, and by building in future technological developments into our current economic evaluations, we are stripping them of their financial benefits, before they are even invented.

Given that European governments have made such errors over the last couple of decades, we have every right to view the crisis with disdain and cynicism. However, such negativity ought to be reconciled with the realisation that austerity remains the optimal strategy to dig us out of this mess.

Just because we lacked the scientific knowledge in the past doesn’t excuse our continued pollution of the atmosphere. In the same way, we need to face up to our past mistakes and change our political spending to give our descendants the best possible chance to achieve life, liberty and the pursuit of happiness.

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