Three types of expenditure shocks

Greece (and the other periphery economies) have experienced three types of expenditure shocks over the last three years and each type has meant that it needs some sort of devaluation (either through wages and prices) or through the exchange rate (if it could). This blog post reiterates what those three types of shocks are and how it is affecting Greece.

To cut a long story short the three shocks are:
1. A sudden stop in foreign lending to domestic banks
2. A sharp contraction in government spending (required to put fiscal positions on a sustainable track)
3. Keynesian multiplier expenditure effects (when people reduce spending – the unemployment that it creates reduces incomes, which in turn reduce expenditures further).

In each one of these cases, the fall in expenditure generates a need for a depreciation. The effect is cumulative; meaning that for a country like Greece the required depreciation is probably very large. And, in each one of these cases, the negative effects could have been offset by an expansionary monetary policy and exchange rate adjustment (or a fiscal transfer from abroad); but in little old Greece they aren’t getting much of either. No wonder things are so bad there. No wonder people are openly discussing for an exit from the euro. Unfortunately, it is starting to get too close to being a disorderly exit for Torrens’ liking.

The rest of this blog illustrates the three shocks with Torrens’ favorite model – the Slater model. So if that bores you, Torrens won’t be at all offended if you want to click the back button now.

The analysis starts before the crisis with the Greek economy producing at Point A in the good old Salter diagram (above) and consuming at C (along a ray OC – we imagine Greeks likes to consume both types of goods in fixed proportion). Since C involves consuming CA more in tradeable goods than it produces, Greece is running a trade deficit, which is being financed by borrowing from abroad.

Now consider the first of our shocks: a sudden stop in external finance as investors became much more risk averse to Greece (perhaps anticipating a possible default). There is a great graph that shows this sudden stop – it is bank lending from Swiss banks to Greece – there is one month in which it suddenly fell from a lot to nothing (must dig that up). In Greece’s case we know that some of the Euro area banks took on this risk, and kept even increased lending. But overall lending to Greece was severely curtailed and for our purposes, let’s say it dried up altogether. This means that the Greek economy is now forced to consume what it produces. If everything could adjust easily, then it would just end up at a point like Point B’ (there once was method to the madness of labelling these points, but that didn’t survive a few edits).
But everything doesn’t adjust quickly. One thing that doesn’t adjust is the wage rate. It is really hard to renegotiate wage contracts downwards. Check out diagram 2 (below). It shows the demand for labour for traded and non traded goods (the demand for non-traded services is flipped around backwards. The total distance along the horizontal axis measures the total supply of labour in Greece. Before the sudden stop, the demand for labour in the traded sectors was as shown by the line that slopes downward from left to right and the non-traded services sector has demand shown by LD1. W1 is the wage that, in the first instance, makes the sum of labour demand for both goods just equal to the total supply (where the two labour demand curves intersect at point R).

 

So when there is a sudden (forced) fall in expenditure in the economy, demand for both goods and services starts to fall, but the producers of traded goods are lucky – the price of their products is determined on the world market and with the exchange rate fixed, there is no fall in demand for their goods, anything that Greeks don’t buy from them, they can export. So the demand for labour in the traded sector remains unchanged and output of traded goods also stays the same (admitted, this is very stylistic). But as demand for services starts to fall, so do services prices – there is no world market and fixed exchange rate to stop that from happening. Restaurants shut down and the demand for services labour falls too. Let’s say it falls to LD2. There is now unemployment at the original wage W1 shown by the distance RS.
On our good old Salter diagram, the sudden stop in financing has caused the economy to reduce consumption along the ray OC to A1. With respect to production, the services sector bears all the adjustment, so that when the point is reached where the economy is consuming just what it is producing, it is at point A1.
That was the first of the three stages of Greece’s crisis. Next came government austerity. This was the subject of a separate blog post. But quickly this is what happens. Since governments generally buy services, not goods, austerity (at a national level) is like a change in preferences – the nation as a whole consumes less services relative to goods. This is shown by a pivot of the ray OC to OC1 ( the steeper ray) and the economy ends up at A2. With the wage fixed, the fall in services demand to LD3 causes unemployment to rise to RT.
The last part of the Greek crisis is the Keynesian multiplier effect that James Haley at New Age of Uncertainty implicitly focuses on in some of his posts and which was skipped over in the earlier post. Those workers who have been made unemployed also cut spending, so that the level of expenditures falls even more than in the first two steps. And when the unemployed reduce their spending (which one tends to do when one losses ones job) they cut spending on both goods and services. This means that demand moves down along the ray OC1 to say OC3. As before, under a fixed exchange rate system, the domestic burden of adjustment falls on the domestic non-traded sectors. But foreigners bear the brunt of the fall in demand for traded goods; with the supply of traded goods staying constant and domestic demand for them falling leading to an excess supply of traded goods in world markets, Greece’s net exports go up. And the economy ends up producing at A3 and consuming at C3. In the labour market, the fall in labour demand to LD3 causes unemployment to rise further to RU.
As said above, in each case, the negative effects could have been offset by an expansionary monetary policy and exchange rate adjustment (or a fiscal transfer from abroad) — the subject of a future post.

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