Economics and the European Crisis

Europe’s austerity disaster is not just a matter of reckless policy decisions by arrogant leaders in the EU, although that is ultimately where the buck stops. Many others have been involved in explicitly or implicitly, directly or indirectly, keeping the crisis going. Among them are assorted economists in various positions whose forecasts have reinforced the desires among political leaders: while the politicians want austerity to work, economists have predicted that it would work.

There is just one problem. Austerity does not work. While it has taken economists quite a while to begin to realize this, others have raised questions for some time now. Among them are business leaders: two years ago British corporate executives began expressing concern about the soundness of continuing EU-imposed austerity policies. The seeds of that doubt have grown, so much in fact that a few days ago Britain’s Chancellor of the Exchequer found it necessary to make a plea to business leaders to stay on board with Britain’s own austerity program. The Guardian reports:

George Osborne has asked business leaders to hold their nerve and continue backing the government’s austerity measures after the Bank of England gave the first signal since the financial crash of a sustained economic recovery. The chancellor told the CBI annual dinner on Wednesday night that the business community should ignore critics of his economic policy who advocate a stimulus package to spur growth and reduce unemployment. … His speech followed a series of forecasts from Threadneedle Street showing the UK recovery strengthening and inflation falling over the next three years. Sir Mervyn King said the outlook had improved, with growth likely to reach 0.5% in the second quarter of 2013, after the 0.3% registered in the first three months.

This is a good example of how the desires of politicians conspire with unrefined forecasts by economists. Anyone who reads a “strengthening recovery” into a 0.2 percent of GDP uptick in growth, from 0.3 to 0.5 percent, is either sloppy or  desperate. Since the difference between 0.3 and 0.5 percent is little more than a margin-of-error change to GDP growth, I am inclined to conclude that at least some of the involved economists are sloppy.

One reason for this is that there have been forecasts of an improvement at the time of the announcement of every new austerity package in Europe over the past few years. I am planning a larger research paper to expose these errors; in the meantime, it is important to ask why economists think that the current austerity policies will have any other effect than the others that have been implemented since 2009.

More on that in a moment. It is important that we do not let the political leaders off the hook. I am firmly convinced that they are desperately looking for any sign that austerity is working – and that their desperation has reached such levels that they are inviting to a conspiracy of the desperate and the willing. It is interesting, namely, to see all the optimistic forecasts that are surfacing now. Politicians who should know better than most of us that austerity does not work, give a surprising amount of attention to those forecasts.

Their desperation is cynical yet understandable. Almost every political leader in Europe has invested his entire political career in supporting austerity. Now he is witnessing more and more critics lining up with The Liberty Bullhorn, pinning the unfolding social disaster on austerity advocates.

The obvious reaction should be to question austerity. After all, I cannot be the only one to ask how much farther the EU is willing to push its member states. For example, how much more can Greece take before the country explodes?

Europe’s leaders are no doubt aware of how close some parts of the continent are to social unrest. So long as austerity-minded politicians cannot provide people with an economic recovery, they know they are accountable for whatever happens.

As an alternative, they use forecasts of willing economists to convince people that the recovery is just about to happen, no matter how microscopic it might be. The Guardian again:

The modest improvement in output over recent months comes against a backdrop of rising unemployment, the lowest wage rises on record … According to the Office for National Statistics unemployment rose by 15,000 to 2.52m in the three months to the end of March. Wages were 0.8% higher in March than a year ago and only 0.4% better if bonuses are taken into consideration, which is the lowest rise in incomes since records began in 2001.

Again, calling this a “strengthening recovery” is clear signs of desperation. There were times when any growth under two percent set off alarm bells, among economists as well as politicians. Now, numbers a fraction as high are raised to the skies as signs of a “strengthening” recovery. From the Sydney Morning Herald:

The dogged recession across the eurozone has snared key economy France, with the latest EU figures released Wednesday [May 15] showing a full year-and-a-half of contraction as tens of millions languish in unemployment. In Brussels, French President Francois Hollande tipped ‘zero’ growth on the national level, blaming an EU-wide, German-led austerity trap — and hitting out at banks for holding back on lending as he and fellow leaders battle to unlock taxable assets hidden in offshore bank vaults or breathe life into training programmes for Europe’s disillusioned youth.

And his recipe is to take it all out in the form of higher taxes instead. Yep. That will really make things better… The fact of the matter is that France desperately needs a complete reversal of its economic policy, with long-term credibility to go with it. The same holds for the entire euro zone, which according to the Sydney Morning Herald is in deep trouble:

official figures showed a 0.2 per cent contraction between January and March, in the longest recession since the single currency bloc was established in 1999. EU data agency Eurostat said output across the 17 states that share the euro — which are home to 340 million people — fell by 1.0 per cent drop compared to the same quarter last year. France notably slid into recession with a 0.2 per cent quarter-on-quarter contraction, with unemployment already running at a 16-year high.

French president Hollande blamed the bad economic news…

on “the accumulation of austerity politics” and a “lack of liquidity” within the banking sector leading to a euro-wide loss of confidence. Fresh from winning France a two-year period of grace from the Commission to bring its public finances back within previously-understood EU targets, Hollande argued that nascent plans to divert state and private investment towards projects intended to get Europe’s youth working would make a difference.

In other words, more government programs on top of government programs that don’t work. If government was the answer, there would not be a crisis in Europe today.

Instead, as the Sydney Morning Herald reports, Europe is heading for yet more of the same, though some economists seem stubbornly unwilling to accept the permanent nature of the crisis:

Following a string of disappointing survey results in recent weeks, Ben May of London-based Capital Economics warned: “We doubt that the region is about to embark on a sustained recovery any time soon.” The latest official European Commission forecast for 2013 published earlier this month tipped a 0.4-per cent contraction, but May said that was way off course with “something closer to a two-per cent decline” likely. His firm’s pessimism was backed by Howard Archer of fellow London-based specialist analysts, IHS Global Insight. “We expect the eurozone to suffer gross domestic product (GDP) contraction of 0.7 per cent in 2013 with very gradual recovery only starting in the latter months of the year,” said Archer.

What reason does he have for expecting a recovery? This is the standard mistake that mainstream economists and econometricians make: they rely heavily on models that are inherently prone to draw the economy toward long-term full employment equilibrium. When they “inject” a change to economic activity, such as an austerity package, their model automatically makes the assumption that this sudden and uncharacteristic change – called a “shock” – will be absorbed and the economy will move on.

Every new austerity package is treated the same way, both by the econometricians who design the models and by the economists who provide the analytical framework. Their take on the European crisis is therefore a series of individual shocks, not a systemic re-shaping of the entire economy. As a result, they always predict a recovery and return to some long-term stable growth path.

To the best of my knowledge there is not a single macroeconomic model out there that has yet incorporated the systemic effects of austerity. Therefore, the economics profession will continue to make systemic forecasting mistakes – and advise politicians based on those mistakes.

Don’t get me wrong. I am not blaming economists for the errors that politicians end up making. But our profession must begin to recognize its almost chronic inability to deal with economic crises. Our forecasting methods can handle regular recessions but are frustratingly inept at dealing with situations that become inherently unstable, such as the current European disaster.

In fairness, I am not the only economist with an unequivocal criticism of austerity. On March 5, Joseph Stiglitz explained in

While Europe’s leaders shy away from the word, the reality is that much of the European Union is in depression. Indeed, it will now take a decade or more to recover from the losses incurred by misguided austerity policies – a process that may eventually force Europe to let the euro die in order to save itself.

Strange conclusion. The euro is not the cause of the crisis. But Stiglitz is probably letting his ideological preferences get in the way of good economic judgment. Otherwise he would do the same analysis has I have and conclude that the crisis is caused by the welfare state.

That said, Stiglitz is eloquent in his criticism of austerity:

The loss of output in Italy since the beginning of the crisis is as great as it was in the 1930’s. Greece’s youth unemployment rate now exceeds 60 percent, and Spain’s is above 50 percent. With the destruction of human capital, Europe’s social fabric is tearing, and its future is being thrown into jeopardy. The economy’s doctors say that the patient must stay the course. Political leaders who suggest otherwise are labeled as populists. The reality, though, is that the cure is not working, and there is no hope that it will – that is, without being worse than the disease.

Well said. But what alternative is Stiglitz proposing? Certainly not that the welfare state must go:

The simplistic diagnosis of Europe’s woes – that the crisis countries were living beyond their means – is clearly at least partly wrong. Spain and Ireland had fiscal surpluses and low debt/GDP ratios before the crisis. If Greece were the only problem, Europe could have handled it easily.

I don’t know where Stiglitz gets his data but here are the debt/GDP ratios for Ireland and Spain in 2003-2008:

2003 2004 2005 2006 2007 2008
Ireland 29.3% 28.7% 27.3% 25.5% 26.1% 44.9%
Spain 44.9% 44.3% 43.2% 41.3% 39.0% 44.2%

In terms of actual euros, the general government debt in Ireland shot up by almost 84 percent from 2003 to 2008. In other words, it was only thanks to strong growth in current-price GDP that the Irish did not see their debt ratio grow faster than it did. They were expanding their government as fast as they could, and certainly more than was healthy for the economy: in 2010 the debt-to-GDP ratio had reached 87 percent, i.e., close to double what it was two short years earlier.

The Spanish situation followed a similar pattern, though with less dramatic numbers than the Irish. The lesson to be learned from this is not that these economies could afford their big governments, but that their big governments survived only because there was enough current-price GDP growth to pay for them. As soon as GDP slacked off, the cost of the welfare state quickly became completely unbearable.

Stiglitz refuses to see this. He goes on to advocate even more government, without a hint of explanation of how the world’s already highest-taxed nations would be able to pay for that:

Europe needs greater fiscal federalism, not just centralized oversight of national budgets. To be sure, Europe may not need the two-to-one ratio of federal to state spending found in the United States; but it clearly needs far more European-level expenditure, unlike the current miniscule EU budget (whittled down further by austerity advocates). … There will also have to be Eurobonds, or an equivalent instrument.

More welfare state spending, more government, more debt, more of the same that brought about the crisis in the first place.

Instead of wanting more of the same and providing politicians with rosy outlooks, practitioners of economics should re-examine the results of their own contributions over the past few years. The ability of hundreds of millions of people to maintain their current standard of living, even support their families, depends on it.