The Failure of Austerity

Just a couple of months ago, the worst scenario for Europe was Greece's default. Now it looks as if  a wider crisis has pervaded the entire Europe, not only peripheral countries.

The European sovereign debt crisis has just now caused a panic reaction in the US and the UK. Banks have decided to prepare for the worst scenario: the break up of the euro. During the night of 28 November, a concerted action of the FED and other major central banks contributed to alleviate the market pressure by easing borrowing at low interest rate, but this will not stop the fire, just save time. Economic analysts believe that Europe has already entered in a recession, and it may spread to other parts of the world economy.

To quote Keynes' words,  we are suffering from a bad attack of economic pessimism. The great economist wrote in his famous essay 'Economic possibilities for our grand-children" (1931):

"The prevailing world depression, the enormous anomaly of unemployment in a world full of wants, the disastrous mistakes we have made, blind us to what is going on under the surface to the true interpretation. of the trend of things. For I predict that both of the two opposed errors of pessimism which now make so much noise in the world will be proved wrong in our own time – the pessimism of the revolutionaries who think that things are so bad that nothing can save us but violent change, and the pessimism of the reactionaries who consider the balance of our economic and social life so precarious that we must risk no experiments."

During the past decade, the United States, like Europe had a fragile banking system due to excessive risks which led to the build up of huge amount of debt. However, Europe's debt stems from cross-border lending,  from the core to the periphery, making the euro zone economies interwoven. German capital (in excess) flowed to southern countries, which were perceived as low risk being in the same monetary area.  In fact, capital went to the private sector, not governments. Then, the bubble burst in Spain, Portugal and Ireland and private spending fell dramatically in debtor countries. 

European leaders were convinced to do the right thing when they introduced austerity measures assuming that the main problem was fiscal irresponsibility. In fact, only Greece had a huge budget deficit ; Spain had a continuous budget surplus before the start of the crisis. Deficits rose due to the economic downturn, caused by the fall of private demand. Despite warnings by wise men, all countries, not just debtor countries were asked to cut public spending and raise taxes. So far austerity policies have not triggered economic recovery but just worsened the debt crisis. 

During the last decade with lax monetary policies, southern economies because of divergence in prices and wages with norther economies. The competitiveness gap can be addressed only if prices and wages fall in the 'peripheral' economies or if prices rise in the 'core' economies. If southern economies are forced to deflate, they will pay a heavy price in terms of job losses and worsen its debt situation. Conversely, northern economies will not accept a rise in prices, which would mean higher inflation for the whole euro area. Last April, the European Central Bank (ECB)  raised interest rates though it was obvious that inflationary expectations were low. Is it when the euro area entered in its critical phase? 

Now, the situation appears out of control, despite the strengthened governance measures taken by European leaders. Italy and Spain are under attack because their public finance have deteriorated as a result of the crisis. Is it economically rational that Italy pays more interests on its debt than Egypt? Markets are driving up too interest rates in countries like Austria and Finland. The reason is that  severe austerity plans and a European monetary policy obsessed with inflation makes it impossible for heavily indebted countries to escape from their debt trap and will inevitably lead to debt defaults* and a general financial collapse.  

The Economist ( Sept. 17) wrote : "So far the euro zone's response has relied too much on two things: austerity and pretence. Sharply cutting budget deficits has been the priority - hence the tax rises and spending cuts. But this collectively huge fiscal contraction is self-defeating. By driving enfeebled economies into recession it only increases worries about both government debts and European banks". 

The entire European economy is being dragged down in a recession by troubled debtor countries. It probably needs a change of direction in fiscal and monetary policies and shift the agenda from austerity toward growth. Throughout the euro zone's debt crisis,  Merkel and  Sarkozy said they would do whatever to save the euro, but they have failed to stop the crisis. They ruled out  joint euro zone borrowing and a bigger role for the ECB in fighting the European sovereign debt crisis, but there are not many options left apart moving to a fiscal union with greater economic powers and the ECB providing unlimited backing to debtor countries. 

We hope that our European leaders will act in the interest of all European citizens. Failing to act would mean taking all of us down the path of ruin.  

* G.Soros wrote a few weeks ago in a prophetic article : "To resolve a crisis in which the impossible has become possible, it is necessary to think the unthinkable. So, to resolve Europe’s sovereign-debt crisis, it is now imperative to prepare for the possibility of default and defection from the eurozone by Greece, Portugal, and perhaps Ireland..