The Economics of the German VAT Hike

I am very happy to be back here at AFOE, if not only, for a brief one-stop guest post about the economics of the German VAT hike and more specifically how market commentators and analists might just be reading the German economy somewhat falsely at the moment in the sense that they are not taking into account the implications of the sustained and evolving process of ageing in the German society. Indeed as Edward noted just a few days ago here at AFOE we might actually be talking about a clash of paradigms or at least a clash between two ways of looking at and interpreting the economic data coming out of Germany and indeed of the entire Eurozone. There are consequently many venues on which this diagreement is fielded and an important one of these is the German economy and more specifically the significance of the VAT hike and below the fold I will give my view on this topic.
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Viva Ricardo!

Guy of these pages recently spoke to a “source” who has an interesting counter-take on the Italian economy and the Italian government’s debt problem to that frequently discussed here. Apparently, the feller says, there’s no chance of “an Argentinian-style blowout” because of the low levels of private debt.

The source is essentially arguing that Ricardian equivalence holds for Italy. That is to say, private and public savings ratios match each other-when the government borrows, the private sector saves, and vice versa. Hence the recovery path after a debt crisis would be that firms and households load up on debt to invest and consume, kick starting a Keynesian recovery.

Now, it’s an observable fact that the Italian government is up to its neck in debt and households are hoarding cash, but that doesn’t necessarily mean that Ricardian equivalence holds. Correlation does not imply causation, and Ricardian equivalence itself is anything but uncontroversial. In fact, it’s not so much an economic theory as a point for discussion, despite having been around almost as long as economics itself. There are some cases that support it – Israel in the 1980s being the classic – but a lot that don’t.

Arguments that fit the facts are always preferable to ones that don’t, but yer man is a braver man than me if he is basing his business decisions on this theory. Especially, I’m not at all clear on what the intermediate analysis/microfoundations are meant to be-how do we get from here to there? Presumably the Eurocrisis option would be one – out of the €, deep devaluation, export-led recovery and follow through to the domestic economy. But the pain of such a course would be epic. And it’s still worth pointing out that I still haven’t met a European business person who considers it even within the realm of the non-crazed (perhaps I don’t deal with enough Italians). More seriously, the panic and Weltuntergangsstimmung that would accompany such a course would have dramatically depressing effects on those ol’ animal spirits.

What of a forced Ricardian equivalence, about the only other story I can see that would satisfy our man’s argument? Imagine that the Italian government retires large quantities (perhaps massive quantities in the course of a debt crisis) of bonds from private and institutional investors and refinances them with the banks. Government paper is a reserve asset, and an increase in reserve assets should mean a multiple increase in credit creation to the private sector. One may recall that some monetarist-minded governments have been keen on manipulating the balance between T-bill-like assets held by banks and bonds held by funds and individuals in order to influence the creation of credit, usually in a deflationary direction – so why not in an inflationary direction?

It’s a bit like reversing the economic flux capacitor, and it’s certainly what in computing we would call a horrible, kludgy hack, and the inflationary bit could easily go well out of kilter, and the whole thing would be dependent on a lot of good will from a lot of banks, but it bears a passing resemblance to some proposals of Paul Krugman’s regarding Japan in the late 1990s. Edward Hugh will no doubt call attention to the similarities between the problems.

Does the weirdness of the solutions mark the optimism of the “source’s” argument? Or is it a long shot..but it might just work? A key number will clearly be the percentage of Italian government debt held by banks.

Book Review: “European Integration 1950-2003: Superstate or New Market Economy?”

Once upon a time, there was a large, intellectually hegemonic, somewhat totalising ideology rooted in a heterodox school of economics. Its advocates proposed to make massive changes to the structure of society and claimed that only such a revolutionary realignment could alleviate the contradictions and failures of the existing order and save the world from stagnation and misery. They claimed that their programme would produce immediate results, and that the only reason it wasn’t immediately implemented was because entrenched interests were manipulating the public against them.

Ultimately, advocates of these principles did gain power in many places and were able to implement elements of their programme. Some came to power through revolutions of various kinds that granted them the near-dictatorial powers they needed to make the changes they believed necessary. Others were able to convince electorates and even elites that theirs was the way of the future. They turned public dissatisfaction to their advantage, especially during economic downturns when people were willing to turn to new solutions and elites feared that the masses would turn against them.

And, they had some arguable successes, but no unambiguous ones. In some places, particularly those where effectively unlimited power had shifted to them, they often maintained highly inequitable regimes which grew harder and harder to justify, faced ever growing public disaffection, and turned to more oppressive and manipulative means to sustain control. This undermined their movement, but despite the best efforts of their enemies was not quite able to kill it off.

In states where more democratic methods had been used, the need to compromise with established interests and to sustain public consent forced them to accept measures often contrary to their initial programme. Their ideological identity tended to shift over time as winning elections grew more important than ideological purity and as the drawbacks of real power became apparent. Actually being held responsible for results forced many members of this tradition to accept their enemies’ interests as at least partially legitimate, and compelled them to less radical legislative programmes.

In some of those nations, these radical parties became increasingly manipulative and difficult to distinguish from their former enemies. But, in a few places, the necessary dilution of their programme brought about an ideological synthesis that appeared successful, and this success in turn showed that the radical programmes they had once advocated were perhaps unnecessary. In the end, ideology had no real hold on them, and the models and methods that seemed to work became the political and economic programme that they were identified with. Their former allies who operated more dictatorial regimes were easily repudiated.

But others were unable to accept that option. They included dissidents who had been burned by the growing authoritarianism of their own failed revolutions, or who were simply unable to accept that their early ideological purity had become superfluous. They were isolated and powerless, only able to function in the states where their former allies had become moderates, leaving them without meaningful public support. They fumed at the world’s unwillingness to go the way they wanted, and increasingly recast the history of the world in terms of their own ideological predispositions. The past became, in their minds, an unending conflict between an ideologically pure vanguard and scheming established interests, a story of their courageous champions betrayed by back-sliding traitors. Ultimately, the world moved on and these radicals virtually disappeared outside of intellectually protected milieux like privately-funded think tanks and universities.

Of course, by the now the astute reader will have recognised that I am talking about the history of neoliberalism.
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