STOCK MARKET WATCH - Monday, 20 February 2012

[Demeter]

4. 3 Myths Drive Europe’s Response to Debt Crisis: Harald Uhlig

http://www.bloomberg.com/news/2012-02-17/how-3-myths-drive-europe-s-response-to-debt-crisis-harald-uhlig.html

In many ways, things in Europe look better than they did just a month or two ago. The European Central Bank is providing banks with almost unlimited cash to buy their governments’ bonds. Yields on Italian debt have declined. This breather is a perfect opportunity to examine some pernicious -- and widely circulated -- myths that have emerged from the crisis and could still do much harm.

Myth No. 1: Italy’s interest burden was unmanageable....one has to wonder: Who is spooking whom? With so much drama over so little, is it any wonder that bond investors have doubts about Italy’s ability to pay?

Myth No. 2: Fiscal austerity means disaster, or growth policies require spending.

It is nice, of course, for governments to be able to borrow money and sprinkle it generously over its citizens. Once the flow stops, however, it should come as no surprise that the citizens are unhappy. That will happen sooner or later because what has been borrowed almost always needs to be repaid. Some people believe there is an alternative: Let’s examine what happens if the government can no longer borrow these generous handouts, and instead has to extract these resources from its own citizenry. Will that promote growth? What about that old Keynesian idea of having some citizens dig holes that other citizens then fill: Wouldn’t that do wonders for the economy?

This is wondrous thinking, indeed. Imagine a beautiful island whose inhabitants don’t need to exert themselves to live happily. Each citizen has an apple tree that each day at noon drops an apple sufficiently large to feed its owner. A citizen’s only task is to pick up the fruit and eat it; otherwise he or she can spend the day at the beach. The per-capita GDP of such an economy would be one apple a day. Enter a government that decides it needs to tax away the entire harvest every day, and then pays each citizen an apple a day for lying on the beach. They would have done so anyhow, but they now get paid by their government for performing a “service.” GDP has been doubled. The services provided by the government are accounted for by how much they cost -- an apple in this example. It would be easy to keep going and even triple or quadruple the original one-apple-per-day GDP.

Now imagine fiscal austerity is imposed, say, by eliminating the government. Yes, GDP would come crashing down; it would fall 50 percent in this example. The citizens, however, are no worse off: They still get to eat an apple a day, just as before. They may even be better off in cases where the government required them to perform an onerous task in exchange for their salaries, such as sitting in a government office all day. Moreover, if the tax imposed on citizens is a labor tax on collecting the apples, then high tax rates might have been preventing them from collecting the apples in the first place...

(Harald Uhlig is chairman of the economics department at the University of Chicago and a contributor to Business Class. The opinions expressed are his own. WHICH EXPLAINS THE SQUIRRELLY IDEAS..IT'S THE CHICAGO SCHOOL, BOYS)