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

Governments must be able to spend strategically to encourage growth, or the crisis will only get worse.

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 deficitsbefore 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.

Indeed, Germany is accused of reaping its ‘surplus’ by suppressing wages with rising productivity (the result of the 'Schroeder reforms', labor reforms named after the former German Chancellor Gerhard Schroeder). The figure below showing Germany’s relatively low unit labor costs has been used by many to suggest that lowering wages is a good thing.

(Source: OECD)

This view has now put much pressure on countries to lower wages through a more flexible labor market as the main route to achieving German-style competitiveness and rebalancing the European economies (making German goods have less of a cost advantage, hence reducing Germany's trade surplus). In other words, because countries within the EU don’t have the option of devaluing their currency, they are forced to turn to internal devaluation in the form of wage decreases and constant monitoring to make sure this happens.

There are several problems with this approach. The first is that actually it is ‘real’ wages that matter most, i.e. wages that also take into account indirect payments and benefits received by a nation’s citizens (things like cheap public housing; state subsidized nurseries; generous unemployment benefits). In this case, the picture in Germany looks different. The data below show that Germany's ‘real’ wages (including welfare contributions) to be relatively high, not low.

Low wages to do not benefit economies. In fact, they take money out of the pockets of consumers and decrease the demand for goods and services. When that happens, companies that cannot sell their products will lay off workers and stop spending on equipment and so on. All of which creates a vicious cycle of further economic deterioration.

In reality, much of Germany’s competitiveness is not due to it paying low wages but instead comes from its high spending in critical areas like R&D, human capital, and its finance system that supports ‘patient’ capital rather than the short-termism of the UK and US model. In fact, Germany’s publicly funded R&D has increased more than that in any other EU country even after the crisis. This is not to say that differences in unit labor costs have played no role, simply that they have been over-emphasized, damaging our ability to think clearly about the root of the problems.

If Germany wants its neighbors to be more ‘stable’ and competitive, then those governments need to be able to spend strategically as Germany has done, and their workers need to have decent wages that support the demand for goods and services. This is currently impossible due to German Chancellor Angela Merkel’s insistence that the cause of the crisis is spending too much and the solution fiscal austerity.

That's the wrong diagnosis and wrong solution.







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