On European austerity
In recent weeks a subtle shift in how officials discuss current economic policy in Europe has become noticeable. At the start of the year the only possible solution for ailing economies, according to Brussels and Berlin, was even more austerity. The Italian elections, the spectacular increase in unemployment to record highs, forecasts that call for a second straight year of Eurozone GDP contraction, and friction between France and Germany that has become increasingly tense – all have conspired to put austerity in a less favorable light.
One also needs to add, as I explained in my previous editorial, that the camp of “austerity at any costs” has experienced two rather painful intellectual defeats. The International Monetary Fund (IMF) acknowledged recently that the negative effects of restrictive fiscal policy were far more profound than what it had previously estimated. And the most famous study linking high public indebtedness with low growth has been debunked, found to have major calculation flaws.
The change in how austerity is viewed can be seen in the European Commission’s decision to postpone the deadline for such countries as France, Spain and the Netherlands to bring their public finances back within the Maastricht Treaty deficit limits of 3% of GDP. This decision may have pleased French President François Hollande, but for many of his countrymen, including the 100,000 who demonstrated against austerity on 5 May in Paris, it is still not enough. So is austerity a “bad” or even “dangerous” idea, as economist Mark Blyth suggests in an in-depth article in the latest edition of Foreign Affairs? The usual economist’s answer here is: “it depends.”
Indeed, economists still debate whether anti-cyclical economic policies, i.e. those that try to smooth out the business cycle, are sensible, necessary or even feasible. However, I don’t know of any economist who favors a pro-cyclical economic policy, i.e. one that would amplify business cycle fluctuations. So is the rule, “don’t do austerity during a recession” correct, and Europe has it all wrong? Not so fast!
Economic policy can be subdivided into fiscal and monetary policy. The interaction between them, the so-called policy mix, is what determines whether an economic policy is anti- or pro-cyclical. The IMF imposed harsh and ultra-restrictive fiscal policies on the Southeast Asian countries in the aftermath of their crisis in 1997, which precipitated recessions in them as deep as the ones Southern Europe is now facing. However, those fiscal austerity policies were mitigated by expansive monetary policies. Asian currencies depreciated markedly against the US dollar, anywhere from 34% for the South Korean won to over 80% for the Indonesian rupiah, from June 1997 to July 1998.
The countries of Southern Europe have enjoyed no similar relief. Monetary conditions remain very tight there despite the latest European Central Bank (ECB) rate cut last week. Indeed, long-term interest rates, measured by government bond yields, are still high (with the noticeable exception of France, but for how long?), and the currencies remain highly overvalued. I am not talking here about the exchange rate of the euro against the US dollar and other currencies, but rather about the implicit exchange rate of the Spanish peseta, the Italian lira and the Portuguese escudo against the German mark, which was fixed forever within the euro. If Spain, Italy and Portugal want to devalue against Germany, they can only do so by slashing their labor costs, which depresses their anemic domestic demand even more.
Europe’s problem therefore is not austerity as such, but the fact that the ECB is forced to adopt an average monetary policy, one too tight for Southern Europe and likely already too expansive for Germany. Indeed, some German politicians expressed their fear of possible inflation after the latest rate cut. You can look at the euro from every possible angle, but you will always come to the same conclusion: the common currency remains a fundamentally flawed construction.