Right and Wrong about Europe

Last Friday I explained that Europe appears to be on its way back to Big Spending country. One major reason is that the policies practiced so far during the Great Recession have proven to be sorely inadequate. Another reason is that Europe suffers from a bad case of conventional wisdom, the default position of which is that there is nothing more important in the economy than the welfare state. As a result, when austerity policies, specifically designed to save the welfare state, fail to do just that while also failing to reignite the economy, voters and political leaders turn to erstwhile solutions such as more government spending. Led there by conventional wisdom, not solid analysis, they are certain to only do more harm to an already ailing patient.

In this situation, clear and crisp crisis analysis is more important than ever. That is the only way to a working solution to the crisis. Unfortunately, the road to such solutions still runs through analytical neighborhoods where arguments about what cause the crisis sprawl in all directions. My blog article from last Friday quoted one example, Dan Steinbock of the India, China and America Institute. This week, Steinbock continues his contribution in the EU Observer::

In the United States, the global financial crisis was unleashed by real estate markets and the financial sector, which caused a dramatic contraction and massive mass unemployment.

That is a superficial explanation. The root cause was a fundamental misinterpretation of a macroeconomic trend. From the late 1970s through the Millennium recession the swings in the American business cycle gradually became weaker. This has been interpreted as a shift to more stable growth, which policy makers in the United States used as a basis for liberalizing the country’s credit markets. One part of this liberalization was an expansion of subprime mortgage lending, a reform that makes sense if the expectation is high GDP growth and as a result high growth in disposable income, then the risks associated with subprime lending are well contained. The debt-to-income ratio would not reach alarming levels, perhaps not even grow at all.

There was just one problem. The trend that was interpreted as growth stabilization was also a trend of weakening growth. In the 2000s the American economy grew at about half the pace of the ’90s. This led to a relative weakening of the ability of American households to keep up with debt payments. Therefore, it is incorrect to say that this was a financial crisis – it was a macroeconomic crisis that was mismanaged and misinterpreted by key political leaders.

It is important to keep this in mind, because it has consequences for how to get the U.S. economy out of the Great Recession. Steinbock lauds the Obama administration for its “stimulus package”, which…

included spending in infrastructure, health and energy, federal tax incentives, expansion of unemployment benefits and other social welfare provisions. It boosted innovation and supported competitiveness.

Frankly, there is no evidence of this. The bulk of the money spent through the American Recovery and Reinvestment Act went to fill revenue gaps in existing government spending programs, at the federal level as well as in the states. This borrowed money may have prevented a massive tax increase, which would have been the other conventional-wisdom option, but it certainly did not expand spending. On the contrary, what was a temporary jump in GDP growth during the stimulus spending, but as soon as it was over the growth rate reverted to pre-stimulus levels. It was not until late 2013 that the very first signs of some sort of recovery were visible. That recovery, though, which is still continuing, is far weaker than it should have been. Why? More on that in a moment. For now, back to the EU Observer, where Steinbock claims that the United States…

was able to rely on common fiscal and monetary policy. When one state got into trouble, it could turn to others for support. Of course, the crisis supported some states and hurt others, but the common institutions worked.

I have worked for state-based think tanks for eight years now, and I have carefully studied state fiscal policy for at least as long. To be perfectly honest, I have no idea what Steinbock is talking about here.

Let’s continue to listen to him, though. Maybe he makes more sense when he turns to discussing Europe:

When the 2008/9 crisis hit Europe, the core economies relied on their generous social models, but structural challenges were set aside. That ensured a timeout but boosted threats. In spring 2010, the crisis was still seen as a liquidity issue and a banking crisis. So Brussels launched its €770 billion “shock and awe” rescue package to stabilise the eurozone. As the consensus view grouped behind Brussels, I argued that the rescue package was inadequate and the austerity policy too strict. Further, it ignored multiple other crisis points. And it was likely to result in demonstrations and violence in southern Europe.

While he is correct about the political fallout of the crisis, he is far too vague on the economic variables that drove the European economy into the ditch. As I explain in my book Industrial Poverty (order your hard copy now or get your ebook version very soon!) the cause of the European crisis is to be found in the structure of the welfare state. This structural ailment is present in the American economy as well, though not as pronounced, but it explains why the Western economies experienced a growth slowdown in the 1980s (EU) and on the heels of the Millennium Recession (U.S.).

So long as the structural problem remains, there will be no recovery in the European economy. The United States has been able to recover despite the weight of government, an aspect that Steinbock misses. He does, however, make a good point about mistakes made by the European Central Bank:

[The] European Central Bank (ECB), led by its then-chief Jean-Claude Trichet, moved too slowly and hiked rates instead of cutting them. When the ECB finally reversed its approach, precious time and millions of jobs had been lost. Subsequently, Trichet’s successor, Mario Draghi, cut the rates and pledged to defend euro “at any cost.” Markets stabilised, but not without huge bailout packages, which divided the eurozone.

Trying to stuff as many explanations as possible of Europe’s perennial crisis into the same article, Steinbock then proceeds to point in many different directions at the same time:

As Barroso and his commissioners began to argue that “the worst was over,” Brussels hoped to reinforce the trust in euro and the EU and deter the rise of the eurosceptics. But hollow promises resulted in a reverse outcome. What’s worse, both Brussels and the core economies failed to provide adequate fiscal adjustment amidst the global crisis and the onset of the eurozone debt crisis, which made bad mass unemployment a lot worse and continues to penalise demand and investment. Further, neither liquidity support nor recapitalisation of the major banks has mitigated the worst insolvency risks in the region. Unlike in the US, many European economies, including Nordic ones, also continued to cut their innovation investments, thus making themselves even more vulnerable in the future. As the crisis spread to Italy and Spain, which together account for almost 30 percent of the eurozone economy, bailout packages could no longer be used. Rather, structural reforms became vital but since they were seen as a political suicide, delays replaced urgency.

Reduced spending on “innovation” is not nearly as important an explanation of the crisis as the structural fiscal imbalances of the welfare state. It is important to separate what matters from what does not matter. Otherwise, one cannot provide solutions to those who are in the position to put them to work.