Options for Europe – Part 86

The title is my current working title for a book I am finalising over the next few months on the Eurozone. If all goes well (and it should) it will be published in both Italian and English by very well-known publishers. The publication date for the Italian edition is tentatively late April to early May 2014.

You can access the entire sequence of blogs in this series through the – Euro book Category.

I cannot guarantee the sequence of daily additions will make sense overall because at times I will go back and fill in bits (that I needed library access or whatever for). But you should be able to pick up the thread over time although the full edited version will only be available in the final book (obviously).

Part III – Options for Europe

[THIS IS THE LAST SUBSTANTIVE CHAPTER – IT INTRODUCES THE APPROACH THAT THE EURO LEADERS HAVE TAKEN AND WHY A DRAMATIC CHANGE IN POLICY IS REQUIRED – IT LEADS INTO THE FINAL SEVERAL CHAPTERS WHICH DISCUSS THE SPECIFIC OPTIONS – WHICH YOU HAVE ALREADY READ. I WILL FINISH THIS CHAPTER BY THE END OF THE WEEKEND AND THEN NEXT WEEK WRITE THE INTRODUCTION AND START CHECKING]

Chapter 18 The European Groupthink – failing to take the correct path

[PRIOR MATERIAL HERE]

[NEW MATERIAL TODAY]

The conservatives regrouped and the resistance to stimulus grew quickly

Most economists were in denial at the outset of the crisis. The dominant macroeconomic models used by mainstream economists for research and teaching categorically failed to predict the crisis even though the massive private debt build-up, prior to the collapse of the US property market, made it certain that the global economy would go into a very deep recession. It was only a matter of when and how deep the recession would be. So it wasn’t surprising that the majority of the economics profession were blithe to the reality that was unfolding, first in the US, and then, relatively quickly, throughout the rest of the world. Most economists had no idea of what was happening and the tools that they use on a daily basis in classrooms and in their journal article writing provided them with no answers. Morever, the curriculum being taught by economics departments around the world is resolutely resistant to change and the lessons learned by the crisis have stil not been incorporated in any serious way into teaching programs.

For most economists, there was a sullen silence in the early days of the crisis. But some of the leading lights in the profession, who had more to lose by way of reputation, given their role in perpetuating the neo-liberal myths of self-regulating, efficient markets, expressed their denial in more aggressive terms. Before long, anti-stimulus views were popping up in opinion pieces in the major conservative media outlets such as the Wall Street Journal, the Financial Times, the Economist and Murdoch’s Fox TV network. Predictions of an inflationary armegeddon where governments would run out of money and the poor would lose all incentives to seek work as a result of the pitiful welfare cheques that they received became a regular occurrence. At the extreme of this ideological resistance to fiscal stimulus, were many well-known economists (such as Robert Barro, Eugene Fama and others) who advocated the so-called laissez-faire option – letting the ‘markets’ adjust with zero government intervention. University of Chicago’s John Cochrane was representative of this uprising when he wrote “Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both” (Cochrane, 2009). Their strategy was simple. If the facts conflicted with their asinine theories, the facts must be wrong. Fellow Chicago academic Eugene Fama, the most well-known proponent of the so-called ‘efficient markets hypothesis’, that had dominated economic thinking prior to the crisis and had given authority to the financial market deregulation, gave an extraordinary interview in early 2010 to the New Yorker. He claimed the crisis was the result of poor “government policy … not a failure of the market” (Cassidy, 2010). When he was asked what had caused the real economic crisis he replied “We don’t know what causes recessions. Now, I’m not a macroeconomist so I don’t feel bad about that.”. The transcript of the interview notes that Fama was laughing at this point. This was purely ideological dogma. There was no ‘self-correcting’ market response possible. The world was plunging very quickly into a total collapse of the magnitude not seen since 1929. There was total failure in the financial markets as parties lost the capacity to assess risk and corrupt and criminal behaviour became an art form. Blinder and Zandi (2010b: 17) concluded that despite obvious critical questions that can be asked about any complex stimulus package, “laissez-faire was not an option”. A failure by the US government to respond in the way they did “would have left … the economy … in a far graver condition” (p.17).

Soon enough, economists everywhere began lecturing the public on the evils of budget deficits, the impending hyperinflation that would result from these ‘excessive’ deficits and the cavalier behaviour of the central banks, and the massive rise in interest rates that would follow. All of these predictions came from their half-baked macroeconomic models and none of them have come to fruition. If the medical profession had displayed incompetence of this magnitude then their certificates to practice would have been withdrawn by authorities and large damages claims would have been awarded against them. But an extremely biased, neo-liberal media, failed to bring these economic zealots to account and the public were increasingly persuaded that the crisis was not one of excessive private debt driven by massive market failure but was rather a sovereign debt crisis brought on by profligate government spending. At that point, the attack on government fiscal activism became almost manic in its intensity and the politicians bought into the fray. Why was there so much resistance to abandoning the failed economic theories? The mainstream economics paradigm is more than a set of theories. Blyth (2013: 100) notes that these mainstream economic theories “enshrine different distributions of wealth and power and are power resources for actors whose claims to authority and income depend upon their credibility”, which explains, in part, why there was such resistance to abandoning them, even though it was clear that they were bereft of any evidential standing.

Blyth characterised the policy makers as “Twelve-Month Keynesians” (Blyth, 2013: 100) as their resolve to continue the growth process increasingly gave way to confused narratives about the need for growth friendly fiscal consolidation, which of-course was a classic example of the law of contradiction where two propositions (growth) and fiscal consolidation (austerity) could not be true together given the collapse of private spending.

While policy makers had initially turned to stimulus as the only option given the scale of the crisis they were facing, the increasingly fanatical opposition to this strategy in the daily media clearly weakened their resolve. By 2010, there was an amazing reversal in the political rhetoric. At the Pittsburgh meeting of the G-20 leaders in September 2009, the communiqué talked about the sufficiency and quality of jobs. The Leaders Statement acknowledged that “the national commitments to restore growth resulted in the largest and most coordinated fiscal and monetary stimulus ever undertaken” (G20, 2009: 1) but that the “conditions for a recovery of private demand are not yet fully in place … [and] … We pledge today to sustain our strong policy response until a durable recovery is secured … We will avoid any premature withdrawal of stimulus” (pp.1-2). There was even a proposal put forward by the then British Prime Minister Gordon Brown to radically reform the IMF, to ensure its resources were used to help nations rather than load them up with debt and onerous conditionality programs (Morris and Grice, 2009).

Less than a year later, the political leaders had abandoned that call and were preaching higher unemployment and increased poverty via austerity packages imposed on fragile communities. This is in the context of dramatic increases in global poverty rates in 2009 due to income losses associated with entrenched unemployment (see ILO, 2010; World Bank, 2010). At the G20 Toronto Summit in June 26-27, 2010 the talk turned to “the importance of sustainable public finances and growth-friendly plans to deliver deliver fiscal sustainability … countries with serious fiscal challenges need to accelerate the pace of consolidation ” (G20, 2010a: 1). Later that year, the annual G20 Finance Ministers and Central Bank Governors Meeting in South Korea, concluded that monetary policy should aim to “achieve price stability”, which thereby “contributes to recovery” (G20, 2010b: 1) and that “ambitious and growth-friendly medium-term fiscal consolidation plans” be implemented (p.1). The emphasis on fiscal consolidation and the need for ‘structural reform’ (aka as labour market deregulation) was affirmed at the G20 Leaders’ meeting in Seoul in November 2010. The tide had turned and the anti-stimulus lobby had won the day. The rapid retreat from fiscal stimulus is exemplified by the UK macroeconomic policy response. They were on the road to recovery courtesy of their fiscal stimulus package until the Cameron government took office in May 2010 and set about pushing Britain down the austerity path. The British economy then laboured under continuous recession until modest growth returned in the first-quarter of 2013. Six years later, the size of the economy (measured by real GDP) is still below the peak before the crisis. Germany followed up the G20 meeting in South Korea by proposing an austerity plan. The German Finance Minister Wolfgang Schäuble said the measures may be “stricter than necessary”, apparently revelling in the thought of cut-backs and hardship (The Guardian, 2010).

The conservative economics and financial press provided a daily arena for this growing hostility to fiscal stimulus. In May 2010, the Economist Magazine, never known for its balanced coverage, claimed that “thanks to incompetence and impotence, governments may become the problem that will drag the world economy down” (Economist, 2010). It went on to assert that “For much of the rich world, however, the most important consequences of Europe’s mess will be fiscal.” On July 22, 2010, the then ECB President, Jean Claude Trichet, published an opinion piece in the Financial Times entitled ‘Stimulate no more – it is now time for all to tighten’, imploring governments around the world to “address our fiscal fragilities”, failing, of-course, to acknowledge that the for currency-issuing governments such as Britain, Japan and the US, there was no risk of governments running out of money, unlike the euro-zone nations, which had opted to use a currency they didn’t issue. Moreover, Trichet rehearsed the mantra that by then had become common among the conservatives – that fiscal austerity far from “jeopardising the economic recovery” would become a “decisive component of economic stability and sustainable global growth” (Trichet, 2010a).

The public was now being bombarded with a myth drawn from the depths of mainstream economic theory that even most economists failed to fully understand – the so-called Ricardian Equivalence Theorem – or in more common parlance – the fiscal contraction expansion. This arcane piece of reasoning claims, in contradiction to everything we know about the real world, that if governments cut their spending and reduce their deficits, private sector ‘agents’ (consumers and firms), who are assumed to have rational expectations, that is, on average they can accurately predict the future, will more than fill the gap because they no longer have to save up in anticipation of future tax hikes which would be required to pay for the deficits. The theory claims that lower deficits mean lower expected future tax obligations, which mean less saving and more spending now. We consider this argument in more detail in Chapter XXX. For the idea to work in theory, several assumptions that can never hold in the real world are required. Further, the theory has never worked out in practice. But for these zealots, the theory is correct no matter what the facts might be. The ECB was a prominent exponent of this discredited theory. They devoted a section of their June 2010 ‘Monthly Bulletin’ to justifying their conclusion that the “beneficial effects of fiscal consolidation are undisputed” because “consumers anticipate benefits arising from fiscal consolidations for their permanent income and consequently increase private consumption” (EBC, 2010: Box 6, 83-85). ECB boss Trichet made many memorable interventions into the debate in his last years of tenure as ECB boss in the style of a evangelical minister. At the Jackson Hole gathering of central bankers in August 2010, he told the audience he didn’t believe the argument that cutting government spending would damage growth because “the strict Ricardian view may provide a more reasonable central estimate of the likely effects of consolidation. For a given expenditure, a shift from borrowing to taxation should have no real demand effects as it simply replaces future tax burden with current one” (Trichet, 2010b).

Not to be outdone, the then French Finance Minister and soon to be IMF boss, Christine Lagarde chimed in against fiscal stimulus. She told the American ABC program ‘This Week’ on October 10, 2010 that “If we do not reduce the public deficit, it’s not going to be conducive to growth. Why is that? Because people worry about the public deficit. If they worry about it, they begin to save. If they save too much, they don’t consume. If they don’t consume, unemployment goes up and production goes down” (ABC, 2010).

The ECB-IMF-German-French alliance all had bought into the notion that fiscal austerity was the way forward. European growth prospects were effectively doomed with the likes of these characters in charge.

The European response

The euro-zone leaders went one further than laissez-faire. They put in place a policy austerity regime that guaranteed the economic collapse would be deeper and longer than otherwise. The most responsible strategy for Europe, given the severity of the crisis and the particular exposure of some European economies and banks, would have been for the European Council to immediately suspend the SGP provisions and for the ECB to announce that they would support all necessary fiscal deficit responses to the spending collapse. The former decision could have been justified under the Article 126 of the Treaty on the Functioning of the European Union (TFEU) relating to the Excessive Deficit Procedure, whereby the Council will consider whether “the excess over the reference value is only exceptional and temporary and the ratio remains close to the reference value”. It was clear that the situation was ‘exceptional’ and with appropriate policy action would have been ‘temporary’. The Council could have stretched the meaning of ‘close’ to be anything it wanted given its propensity to continue bend the rules anyway. The ECB could have immediately announced a program such as the Securities Markets Program (SMP) whereby they promised to buy up unlimited volumes of national government debt in the secondary markets. If the SMP had have been introduced in 2008 rather than 2010, things would have been much different. No Treaty change would have been required for either of these ‘ad hoc’ arrangements to be put in place. While obviously outside the ‘spirit’ of the European mindset that created the flawed EMU design, the responses would have saved the euro-zone from the worst. Those two decisions would have stopped the crisis in its tracks. There would have been minimal output and employment losses and private sector confidence would have returned soon enough. Fiscal deficits and public debt levels would have been much higher but growth would have returned relatively quickly and the responses of the private bond markets would have been irrelevant.

History tells us that the European policy makers did exactly the opposite. By 2009, the European Council had determined that 16 of the 17 euro-zone nations had ‘excessive deficits’ under the meaning given in Articles 104.6 and 126.6 of the Treaty. Only Luxembourg escaped the net. The fact that virtually the whole euro-zone economy was in default of the fiscal rules should have told the political leaders the obvious – that the rules were poorly calibrated in relation to likely scenarios. But that was not the response and millions of Europeans lost their jobs and prosperity unnecessarily because of the policy folly that ensued.

The first mistake the European policy makers made was to quickly fall into ideological mode and claim that the crisis was the result of excessive government spending. In the early days of the collapse, the news media was full of stories of lazy Greeks and a lax government running up huge spending bills they could not afford. This was meant to be an explanation for the problems that sovereign debt markets were encountering as private bond investors realised that because the euro-zone nations do not issue their own currency they are at risk of insolvency. The real cause of the crisis – the spiralling and unsustainable private debt build-up and the exposure of the European banks to that debt – was pushed quietly to the background by the Troika and only occupied minds when the Troika sought to ensure the big French and German banks would not fail and that the Spanish, Irish and Greek taxpayers would pay the bills to make that happen. The fact that these ‘bailout loans’ were added to the outstanding sovereign debt of these nations only exacerbated the situation. Further, there was no evidence that government spending among the Member States was in any way ‘out of control’. Greek, alone was running larger deficits than most. But Spain and Ireland were exemplars of fiscal prudence as defined by the nonsensical SGP rules.

Yet it was in the ideological interests of the neo-liberals to deny and blur the reality so that they could reconstruct the private debt crisis in Europe (and elsewhere) as a public debt crisis, which had its roots in out of control government spending. The solution then was obvious – the need for fiscal austerity. The SGP rules then gave these zealots the cover needed to impose the austerity. All the aggregates that really matter like GDP and employment growth and unemployment were considered expendable. There was a mindless zeroing in on the SGP rules and financial numbers, with the understanding of what was driving the rising deficits and debt ratios ignored. As Mark Blyth noted “treating it as a crisis brought about by debt-fueled consumption and profligate state spending is to confuse correlation (they happened at the same time) with causation (out-of-control spending caused the crisis)” (Blyth, 2013: 97).

A reasonable interpretation of what was going on in Europe and the UK is that the GFC was an inconvenient disruption to the neo-liberal program of deregulation, retrenchment of government welfare programs, and income redistribution away from workers towards capital. The GFC had conveniently provided some very high fiscal numbers, which the conservatives sought to use evidence for their case that governments are bad. The public was encouraged by daily media headlines and interviews with economists and political leaders to believe that the low growth was the result of the high deficits, rather than the other way around. The return to austerity under the smokescreen of the fiscal crisis allowed the neo-liberals to resume business as usual.

The language of morality also became prominent, which reflected the religious nature of the crusade against fiscal stimulus. Financial Times journalist Wolfgang Münchau abhorred the decision by the French government in September 2009 to abandon any aim to reduce its fiscal deficit to below 3 per cent by 2012 and claimed other governments (Greece, Italy, Portugal and Spain) were similarly recalcitrant. In contradistinction, Münchau (2009) said that “Germany … has committed itself to the virtuous path.” Former European Central Bank’s executive board member, German economist Otto Issing claimed that Greece “wasted potential savings in a spending frenzy” (Issing, 2010). German Finance Minister Wolfgang Schäuble told the press before a two-day summit in Brussels in March 2010 on whether there should be Community support for Greece, that “an automatic system that hurts those who persistently break the rules” was needed to punish the “fiscal sinners” (Traynor, 2010). Even Australian journalist felt compelled to lecture us about the “decadence” and “depravity of modern Greece” in relation to its fiscal deficit and public debt ratio (Sheehan, 2010). Language matters and we examine this issue in more depth in Chapter 20.

[TOPICS LEFT TO COVER IN THIS CHAPTER – THE BAILOUTS, THE FISCAL COMPACT AND THE EXPORT-LED GROWTH MANIA]

Additional references

This list will be progressively compiled.

ABC (2010) ‘Interview with Christine Lagarde’, This Week, October 10, 2010. http://abcnews.go.com/ThisWeek/video/interview-christine-lagarde-france-finance-minister-christiane-amanpour-stimulus-europe-11844525

Australian Treasury (2009) ‘The Return of Fiscal Policy’, Presentation to the Australian Business Economists Annual Forecasting Conference, Sydney, December 8, 2009. http://www.treasury.gov.au/documents/1686/HTML/docshell.asp?URL=Australian_Business_Economists_Annual_Forecasting_Conf_2009.htm

Barber, L. and Barber, T. (2008) ‘Barroso warns on protectionist pressures’, Financial Times, March 2, 2008. http://www.ft.com/intl/cms/s/0/3ab2bf90-e8a1-11dc-913a-0000779fd2ac.html

Blinder, A. and Zandi, M. (2010a) ‘How the Great Recession Was Brought to an End’, July 27, 2010. https://www.economy.com/mark-zandi/documents/End-of-Great-Recession.pdf

Blinder, A. and Zandi, M. (2010b) ‘Stimulus Worked’, Finance and Development, December, 14-17. http://www.imf.org/external/pubs/ft/fandd/2010/12/pdf/Blinder.pdf

Blyth, M. (2013) Austerity: The History of a Dangerous Idea, New York, Oxford University Press.

Cassidy, J. (2010) ‘Interview with Eugene Fama’, The New Yorker, January 13, 2010. http://www.newyorker.com/online/blogs/johncassidy/2010/01/interview-with-eugene-fama.html

Cassidy, J. (2013) ‘Why is Europe so messed up? An illuminating history’, The New Yorker, May 20, 2013. http://www.newyorker.com/online/blogs/johncassidy/2013/05/austerity-an-irreverent-and-timely-history.html

Cochrane, J. (2009) ‘Fiscal Stimulus, Fiscal Inflation, or Fiscal Fallacies?’, mimeo, February 27, 2009. http://faculty.chicagobooth.edu/john.cochrane/research/papers/fiscal2.htm

Congressional Budget Office (2011) ‘Estimated Impact of the American Recovery and Reinvestment Act on Employment and Economic Output from October 2010 Through December 2010’, Washington, D.C., February. http://www.cbo.gov/sites/default/files/cbofiles/ftpdocs/120xx/doc12074/02-23-arra.pdf

ECB (2010) Monthly Bulletin, June 2010. http://www.ecb.europa.eu/pub/pdf/mobu/mb201006en.pdf

Economist (2010) ‘Fear Returns: Governments were the solution to the economic crisis. Now they are the problem’, May 27, 2010. http://www.economist.com/node/16216363

European Commission (2008) ‘Autumn economic forecast 2008-2010’, IP/08/1617, Brussels, November 3, 2008. http://europa.eu/rapid/press-release_IP-08-1617_en.pdf

European Council (2010) ‘Statement by the Heads of State and Government of the Euro Area’, Brussels, March 25, 2010.

Federal Reserve Bank (2007a) ‘Press Release’, August 7, 2007. http://www.federalreserve.gov/newsevents/press/monetary/20070807a.htm

Federal Reserve Bank (2007b) ‘Press Release’, August 10, 2007. http://www.federalreserve.gov/newsevents/press/monetary/20070810a.htm

Federal Reserve Bank (2007c) ‘Press Release’, August 17, 2007.
http://www.federalreserve.gov/newsevents/press/monetary/20070817b.htm

Feyrer, J. and Sacerdote, B. (2011) ‘Did the Stimulus Stimulate? Real Time Estimates of the Effects of the American Recovery and Reinvestment Act’, Working Paper 16759, National Bureau of Economic Research.

G20 (2009) ‘G-20 Leaders Statement’, The Pittsburgh Summit, September 24-25, 2009. http://www.oecd.org/g20/meetings/pittsburgh/G20-Pittsburgh-Leaders-Declaration.pdf

G20 (2010a) ‘G-20 Toronto Summit Declaration’, June 26-27, 2010. https://www.g20.org/sites/default/files/g20_resources/library/Toronto_Declaration_eng.pdf

G20 (2010b) ‘Communiqué, Meeting of Finance Ministers and Central Bank Governors’, Gyeongju, Republic of Korea October 23, 2010. https://www.g20.org/sites/default/files/g20_resources/library/Communique_of_Finance_Ministers_and_Central_Bank_Governors_Washington_D.C._USA_April_23.pdf

G20 (2010c) ‘The G-20 Seoul Summit Leaders’ Declaration’, November 11-12, 2010. https://www.g20.org/sites/default/files/g20_resources/library/Seoul_Summit_Leaders_Declaration.pdf

ILO (2010) Recovery and growth with decent work, International Labour Conference, 99th Session, 2010, Geneva, June 18, 2010. www.ilo.org/wcmsp5/groups/public/—ed_norm/—relconf/documents/meetingdocument/wcms_140738.pdf

Issing, O. (2010) ‘Europe cannot afford to rescue Greece’, Financial Times, February 15, 2010.

Morris, N. and Grice, A. (2009) ‘Brown’s assignment for next G20 meeting: a blueprint for IMF reform’, The Independent, April 4, 2009.

Münchau, W. (2009) ‘Diverging deficits could fracture the eurozone’, Financial Times, October 4, 2009.

The Guardian (2010) ‘Germany joins EU austerity drive with €10bn cuts’, June 7, 2010. http://www.theguardian.com/business/2010/jun/06/germany-deficit-greece-privatisations

Sheehan, P. (2010) ‘Greece laid low by its decadence’, Sydney Morning Herald, May 15, 2010. http://www.smh.com.au/federal-politics/political-opinion/greece-laid-low-by-its-decadence-20100516-v66z.html

Sinn, Hans-Werner (2010) ‘How to Save the Euro’, The Wall Street Journal, April 20, 2010.

Traynor, I. (2010) ‘Eurozone leaders lock horns over whether to rescue Greece’s economy’, The Guardian, March 25, 2010. http://www.theguardian.com/business/2010/mar/24/eurozone-leaders-greece

Trichet, J.C. (2010a) ‘Stimulate no more – it is now time for all to tighten’, July 22, 2010. http://www.ft.com/cms/s/0/1b3ae97e-95c6-11df-b5ad-00144feab49a.html

Trichet, J.C. (2010b) ‘Central banking in uncertain times: conviction and responsibility’, Speech at the symposium on Macroeconomic challenges: the decade ahead, Jackson Hole, Wyoming, August 27, 2010. www.ecb.int/press/key/date/2010/html/sp100827.en.html

UNCTAD (2010) ‘Trade and Development Report, 2010, United Nations Conference on Trade and Development, New York. http://unctad.org/en/Docs/tdr2010_en.pdf

Walker, M. and Davis, B. (2010) ‘Germany Backs European Version of IMF’, Wall Street Journal, March 8, 2010. http://online.wsj.com/news/articles/SB10001424052748704706304575107814218903120

World Bank (2010) Global Economic Prospects 2010, International Bank for Reconstruction and Development/The World Bank, Washington, D.C. http://siteresources.worldbank.org/INTPROSPECTS/Resources/334934-1322593305595/8287139-1322593351491/GEP2010bFullText.pdf

(c) Copyright 2014 Bill Mitchell. All Rights Reserved.