Europe, Austerity, Interest Rates.

I think it's oversimplified to say that Europe has instituted austerity measures and they've failed. I don't think they've been successful but it's complicated. Also, all of the numbers I'm using I'm completely making up without regard to scale. That being said:

A government can raise money through taxes or by borrowing ("debt-financing"). There are (IMO) legitimate reasons to borrow money to pay for things, and there are (IMO) illegitimate reasons for a government to borrow money. But the bottom line is that governments in Europe often borrowed a lot of money.

A note about interest rates: they could borrow the money cheaply. Which means low interest rates. A low interest rate: borrowing $1,000 for a year and at the end of the year paying back $1,001. A high interest rate: borrowing $1,000 for a year and at the end of the year paying back $1,500. Low-risk borrowers get low interest rates. High-risk borrowers get high interest rate.

Think about loaning to someone you trust versus someone you don't trust. You're willing to loan money to someone you know will pay you back, it's a very safe investment. You're very unwilling to loan money to someone you think will never pay you back. As a way of compensating for this, people charge a lot of money when they're worried they might not get it back, and people charge very little money when they know they'll be paid back.

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Example of high-risk borrowers versus low-risk borrowers in real life, using real numbers:

A source for the numbers if you wantto see themyourself, an article on paydayloans and a payday loancalculator

An extremely safe loan is loaning to the US federal government. You can loan them money for a year and earn about .18% interest. Meaning:

• Loan them $100
• In a year you get paid back $100.18

Or from the point of view of the borrower (the US federal government):

• Borrow $100
• In a year pay back $100.18
• Pay an annual interest rate of .18%

A slightly riskier, but still very safe, loan is loaning to a city or county in the US. You can loan them money for a year and earn about .208% interest. Meaning:

• Loan them $100
• In a year you get paid back $100.208

Or from the point of view of the borrower (a city or county in the US)

• Borrow $100
• In a year pay back $100.208
• Pay an annual interest rate of .208%

An extremely risky loan is loaning to someone as a payday loan. Interest rates vary, but let's assume a common interest rate of 15.5%, a loan of $100, and *instead of a year* the loan is only for 2 weeks. Meaning:

• Loan them $100
• In two weeks you get paid back $115.50

Or from the point of view of the borrower (the person getting a payday loan)

• Borrow $100
• In two weeks pay back $115.50
• Pay an annual interest rate of 403% (yes: four hundred and 3; it's not a typo)

So you can see how some people can borrow money easily, only having to pay a little for it. And how some people have difficulty borrowing money, and have to pay out the ass for it.

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A government is usually seen as really stable. Meaning you can lend them money without worrying that they'll go bankrupt, and you know they can always pay you back by raising taxes. So the governments in Europe borrowed a lot of money and they borrowed it cheaply and easily.

So a simplified hypothetical budget:

Revenue

$5,000 through taxation

$3,000 through borrowing

Expenses

$7,500 spending

$500 paying loans

Total

Balanced ($0)

Then the financial crisis hit. Suddenly 1) they have to pay more for the money they've borrowed 2) they have to pay more to borrow additional money 3) citizens have less money to pay in taxes 4) more citizens need more support (unemployment, welfare, food stamps, etc)

Now their budget looks like:

Revenue

$4,000 through taxation

$2,000 through borrowing

Expenses

$8,000 spending

$1,000 paying loans

Total

Non-balanced: $3,000 gap

They're taking in $6,000 and spending $9,000. You can't do that!

Which leaves 3 options:

1) Raise taxes. That's unpopular, and it takes money out of the economy at the precise time your economy needs more money. So that's not a good call.

2) Austerity measures. This means spending less. Which means that at the precise time your citizens need help and your economy needs increased spending, you're spending less. So that's not a good call.

3) Borrow more. This will put you farther in debt. The more you borrow, the riskier you become, and the more it costs to borrow. So that's not a good call.

So a lot of governments chose austerity measures. Remember when I mentioned the whole "your economy needs increased spending, you're spending less" problem? Yeah, it's a serious problem.

People spending money is what keeps the economy going. Think of it as lube in an engine that keeps the whole thing running smoothly. You spending money one place gives that person money to spend another place which gives that person money to give you, and so on. It's a giant circle, a smoothly running machine, a well lubed engine.

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Simplified example:

Imagine a household composed of two people: Mother Mary and Daughter Diane. The mother owns a lumber yard and the daughter goes to school. Now imagine a business, an ice cream shop owned by Ian.

Mary earns money, she gives $5 to Diane every week. Diane spends $5 at the ice cream shop. That $5 is now Ian's $5. Ian turns it into $6. Ian then spends $6 at the lumber yard. Now Mary has $6.

• Mary has $5
• She "spends" it by giving $5 it to Diane
• Diane spends it by giving $5 it to Ian
• Ian spends it by giving $6 it to Mary

AKA it's all good. $5 has become $6. Rinse, repeat, keep churning out the dough.

Because of some CDO swap gone bad by a banker in London who complains about his annual $5,000,000 bonus turning into a mere $4,500,000, lumber becomes more expensive. Mary can only afford to give Diane $3. Diane spends $3 at the ice cream shop. That $3 is now Ian's $3. Ian turns it into $3.50. Ian then spends $3.50 at the lumber yard. Now Mary has $3.50.

• Mary has $3
• She "spends" it by giving $3 to Diane
• Diane spends it by giving $3 to Ian
• Ian spends it by giving $3.50 to Mary

Well, that's still good. $3 has become $3.50

But now Mary has less money to spend. So she stops giving Diane anything. (OK, her love, but no allowance.)

• Mary has $0
• She doesn't give anything to Diane
• Diane doesn't give anything Ian
• Ian doesn't give anything to Mary

And now we have a serious problem. No one is earning money because no one is spending money.

Keep in mind this situation wasn't brought about a cabal in Geneva. No one bribed a politician to manipulate the economy in such a way that non-rich people get the short end of the stick.

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When people stop spending money the engine stops running well. So you know the problem that governments faced by the financial crisis? That gap of $3,000? When people stop spending money it places further pressure on that gap. It exacerbates the problem. Revenue goes down (no money, how can someone pay taxes when they don't have money?) and the need for spending goes up (more unemployed people, more need for assistance, etc).

So how do we fix this?

Austrian economics says that it's better to let the system sort itself out. Yes, there's short term pain. But that pain is necessary. Like ripping off a bandage: it's better to do it quickly and painfully and move on. This means austerity measures. Not surprisingly, advocates of this view are often wealthy or motivated by resentment (i.e., LOOK AT THE DEBT, IT'S TRIPLED BECAUSE THE MEXICANS GET WELFARE AND ABORTIONS).

Keynesian economics says that it's better for the government to intervene. So you have things like stimulus packages (even though about 40% of that was tax cuts...) and TARP. Intervening by borrowing money which increases the debt in the short term. Wait a minute, you might say, doesn't borrowing money make it more expensive and turn into a spiral?

Remember those incredibly low interest rates for the US federal government? They're an incredible blessing! The US federal government can borrow money for a year at 0.18% while, for example, Greece can do the same thing at 14%. US treasury bonds are about the safest investment, while Greek bonds are incredibly risky. The economy of the United States is growing at 2.2%, Greece is shrinking at -5%. That's the fundamental difference between the general case and the specific case.

But back to the austerity. When the government cuts back on spending it takes more money out of the economy. Remember the above example with the Mary to Diane to Ian to Mary loop? It's broken in a bad economy. You have to remember that it's not just her link with Ian, it's her link with many people and their subsequent link. As an aside, President Bush wasn't wrong when he told people to go shopping after 9/11. Anyway, given austerity measures we might see things like:

• The police force has been scaled back, Mary's business is now in a more dangerous neighborhood requiring more money for insurance
• The roads aren't maintained as well leading to a higher cost for auto maintenance
• Her child's school stops offering subsidized lunches, leading to a higher cost for Mary
• The post office closed, now Mary has to drive across town daily. Leading to increased transportation costs

And so on.

I wasn't being entirely accurate when I said Mary's link with everyone was broken. It was damaged. And all of these things caused by austerity measures damages it further, leading to a feedback loop of economic failure. As fewer people participate in the economy, it then necessarily causes fewer people to participate which then necessarily causes fewer people to participate, and so on.

So when the governments in Europe instituted austerity measures they helped increase the intensity of that loop. And by doing so they found themselves in the exact same budget gap problem they had before, only now it's worse. They have to figure a way out of it and there's no easy answer.

So when someone says:

Look at how the debt has gone up recently! Gosh darn high debt is bad therefore Obama is mismanaging our money by wasting it on welfare queens and illegals. I'm not bigoted or resentful, that's just the only frame of reference I have for thinking about the government or taxes.

 Don't be misled.