Emerging Panic over Stagnant Europe

Austerity is spreading its ever darker shadow over Europe. It has now grown to such proportions that it is beginning to really scare members of Europe’s political elite. Among the deeply concerned are members of the French prime minister’s cabinet. This is big news that few seems to notice. One who does, though, is Ambrose Evans-Pritchard, sharp-eyed editor with The Telegraph:

French president Francois Hollande is facing an anti-austerity revolt from his own ministers as he pushes through a fresh round of tax rises and austerity to meet EU deficit targets. Three cabinet members have launched a joint push for a drastic policy change, warning that [spending] cuts have become self-defeating and are driving the country into a recessionary spiral.

And these are no small words coming out of the French cabinet:

“Its high time we opened a debate on these policies, which are leading the EU towards a debacle. If budget measures are killing growth, it is dangerous and absurd,” said industry minister Arnaud Montebourg. “What is the point of fiscal consolidation if the economy goes to the dogs. Budget discipline is one thing, cutting to death is another,” he said.

See I told you so. But where have the French been over the past five years when Greece has been sinking into the dungeon of austerity, mass unemployment, poverty, economic despair and political extremism? What did the French do to help Spain avoid bone-crushing austerity that has turned middle-class Spaniards into food scavengers? Did a single leading French socialist lift as much as an eyebrow when Portugal was almost torn apart by social unrest following EU-imposed austerity?

Evans-Pritchard does not bring up this European context, but his analysis of the French socialist austerity revolt is nevertheless worth listening to:

Mr Hollande will on Wednesday unveil another round of belt-tightening worth €12bn, even though Paris is already carrying out the harshest fiscal squeeze since the Second World War and France may already be in a triple-dip recession. The cuts are hard to reconcile with Mr Hollande’s campaign pledge last year to end austerity. They have set off furious criticism across the French Left. “Austerity is no longer tenable in Europe today with millions of unemployed,” said social economy minister Benoît Hamon.

So Mr. Hollande has shifted foot. His original plan was to “end austerity” by having government spend more, not less, while still raising taxes through the roof. That alternative does about as much damage down the road as austerity, especially if at the same time you are trying to balance the government budget.

And at the end of the day, the balanced budget is all that matters. It is the pillar upon which Germany has built its unrelenting campaign against “undisciplined” euro-zone members. The doctrine of the balanced budget was one of the cornerstones of the EU constitution – originally turned into constitutional mandate in Article 104c of the Maastricht Treaty of 1992 – and has since been elevated to religious doctrine. No one in Europe questions the economic logic in, so to speak, putting the balanced budget before the horse.

Not even the French who break ranks with the austerity-touting consensus. However, they actually don’t have to, because the nature of the austerity measures is such that it really does not deviate much from the standard European doctrine of maxing out the size of government:

Almost all the austerity measures will come from tax rises, pension fees and a “green’ levy, rather than spending cuts. The state sector will climb to a record 56.9pc of GDP this year as the economic contraction eats into the private sector. Public spending has reached Scandinavian levels … Critics say the French tax squeeze is not even helping to curb borrowing. France is at growing risk of a debt trap as the slump itself erodes tax revenues. Public debt will jump to 94pc of GDP next year, a drastic upward revision from 90.5pc.

Spending cuts would have made no real difference. Look at Greece, Portugal, Spain and Cyprus. The problem is the over-arching focus on balancing the budget in a recession.

Evidently, as Evans-Pritchard reports, the bad shape of the European economy, after years of unrelenting spending cuts and tax increases, is so bad that the political elite is beginning to panic:

A report prepared for EMU finance ministers over the weekend by the Breugel forum in Brussels said the eurozone’s crisis strategy is a failure, a nexus of confused policies that cut against each other. Fiscal overkill is stopping the banks returning to health, while foot-dragging on the EU bank union is perpetuating the credit crunch in the Club Med bloc. Sky-high unemployment is eroding job skills and “undermining Europe’s long-term growth potential”. Low growth is making it “much tougher for hard-hit economies in southern Europe to recover competititveness and regain control of their public finances”.

This is a good, first look at Europe’s deep structural problems. Austerity is not a structurally oriented policy, but it interacts with a lot of structural features of the European economy that, taken together, conspire to trap the economy in perpetual stagnation. One of those structural features is the system of excessively rigid labor laws. By interfering with the need of businesses to make flexible adjustments of their work force, Europe’s hire-and-fire laws significantly raise the cost of doing business, especially for smaller firms.

As a result, Europe’s work force is not working up to its potential. Tens of millions of workers get stuck in jobs that do not produce optimally, and tens of millions of others get stuck in unemployment. One symptom of this is low labor productivity, which the Breugel Forum notes in its report about Europe’s labor productivity:

Since 2007, the EU15 has taken a productivity holiday, while productivity has increased rapidly in the US (Figure 3). In terms of total factor productivity, both the EU15 and EU12 lag behind Japan. Even economically stronger countries, such as Germany, lag behind the US, and the evolution in the United Kingdom does not differ markedly from that of continental economies. Some hard-hit countries, such as Ireland, Spain and Latvia, have apparently recorded outstanding labour productivity performances since 2007, but most of these gains have been due to compositional changes, such as the shrinkage of low-productivity construction and low value-added services, and the total factor productivity developments in these countries were weak.

By making it excessively costly for businesses to downsize in tough times, Europe’s governments cause a phenomenon called “labor hoarding”, the effects of which the Breugel Forum report explain well:

Labour hoarding can partly explain the initial response to the shock of the recession. Employment contracted by five percent between 2007 and 2010 in the US, while in several European countries the employment shock was of limited magnitude. Public policies, such as Kurzarbeit, a scheme financed by the German government to support part-time work and keep workers employed, were one factor behind this response. Firms also hoarded labour, expecting a rebound and thereby limiting the initial rise in unemployment. Five years on, however, the productivity setback has become permanent, contributing to lower potential output. This cannot be regarded as a cyclical phenomenon anymore. In the short run, weak productivity performance can be related to insufficient demand through the so-called productivity cycle. But the weak cyclical position of the economy cannot explain sustained poor productivity.

It is good that some Europeans with access to the “big stage” are beginning to look deeper into what is really happening to the deeply troubled European economy. However, so long as they do not realize that the welfare state is the root cause of the problems, they will not be able to prescribe a medicine that could actually cure the patient.

The lack of insight into Europe’s ailment will drive the continent straight into the economic wasteland. As tepid as the American recovery is, it offers an infinitely better platform for the future than what the Old World could ever come up with.

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