Austerity Plans Are Based on the Wrong Diagnosis of the Wrong Problem -- And May Plunge Europe into Depression

Even if European politicians ‘get their acts together,’ the eurozone crisis will not be solved by a new ‘Fiscal Compact’ obsessed with austerity, i.e. tight rules for all member states on their spending. The agreement, which is intended to save the single currency, is not a “fiscal” anything, since that word usually refers to government spending. The plan is really an Austerity Compact – an attempt address economic malaise based on upside-down thinking.

And it won’t work. Because as John Maynard Keynes revealed, the worst thing that a government can do during a recession is to lower spending. And yes, all of Europe is in a recession, and probably a depression soon. Private investment spending is cyclical in nature -- too much during up-boom periods and too little during down periods. That’s why government spending must act as a counter-balance. Instead, what we have seen is government actions fueling private sector spending (with lower interest rates and lower taxes) in boom periods (like the 1990s), and now withdrawing spending during the recessionary period when there is not enough private investment.

This is exactly the opposite of what should happen.

But the main problem with the ‘Austerity/Fiscal Compact’ solution is not just that it won’t work for Keynesian reasons, but that it is based on exactly the wrong diagnosis of the problem. The austerity solution assumes that the problem with countries like Portugal, Ireland, Italy, Greece, and Spain (PIIGS) that are peripheral to the eurozone (and the list is growing) is that they ‘spent too much.’ As I have now argued endlessly in various media outlets, this idea is completely false. In fact, the pre-crisis deficits of all EU countries (except Greece) were in line with the target rates of 3-4%. Deficits started to rise in 2007 after government spending rose to fund stimulus packages and bailouts. If you look at Spain, currently one of the most problematic countries, you will find that it had one of the lowest deficits before the crisis, and even one of the lowest ratios of debt to economic output (debt-to-GDP).

Growth and Speculation are the True Culprits

Instead, the real problem has been two-fold: a growth crisis and a speculation crisis.

The growth crisis developed from the fact that the periphery countries, especially Italy and Greece, had not been making the ‘smart’ investments in areas like human capital formation, training and research and development (R&D) which can increase productivity. In fact, Italy has one of the lowest rates of R&D spending (and productivity growth) in Europe. And if productivity remains low, so will growth.

As long as the growth rate remains lower than the interest rate paid on the debt, the debt/GDP ratio will by definition keep increasing. And it is this ratio that worries investors.

The speculation crisis has arisen because the European monetary union was not supported by a proper European Central Bank willing to act as a lender of last resort. This failure has caused bond market speculators to place bets on the ability of countries to pay back their high debts. Look at the case of the UK: Even with a very low growth rate, the UK has not been attacked (yet) by the bond markets because despite its low growth, it will never default on its debts, given the willingness of the Bank of England to be the lender of last resort.

Driving Down Wages Will Hurt, Not Help

But coming back to the problem of growth and ‘competitiveness’, many (even progressive commentators) have pointed the finger to so-called ‘structural reforms’ and/or the need for the ‘global imbalances’ to be corrected. While corruption must indeed be fought against, tax evaders should be punished, and labor markets need to help the young and not only the old, it is wrong to think that the problem stops there.