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..  

Two (or three) speed Europe

As the crisis has reached its peak,  the division between the core and the periphery of Europe becomes more acute. Neither the European councils nor the G-20 summit have triggered confidence in the economic governance system that was put in place with great difficulties. Tensions over Italy and Spain have in fact led to the idea of a two speed Europe with a hardcore around France and Germany while tensions between the euro area and the UK are revived. The prospect of a deep recession, as warned by the ECB, feeds the economic pessimism over the current possibility to deal with the crisis within the confines of the Lisbon treaty.

P. Krugman  argues that the euro crisis is about 'original sin' (in the economic sense), meaning that countries like Italy, by joining the euro, converted its status of economic power, as a country issuing its debt in its own currency into a situation with debts in euro, which makes it more vulnerable to financial crises. This principle was inherent in the European monetary union, but no governance rules were  introduced to help address possible financial crisis due to the financial orthodoxy imposed by Germany. 

Beyond this apparent contradiction,  N.Roubini explains that the structural causes of the eurozone crisis are much deeper and do not lie in a fiscal crisis. The divergence in real exchange rates and the strength of the euro - which introduces a competitive shock on weaker economies- largely explain the current crisis. Over the past ten years, the southern economies , which include Cyprus, Greece, Italy, Ireland, Portugal and Spain- were essentially consumers ' of first and last resort', with budget gaps exceeding their respective incomes. In addition, the private sector had also accrued considerable debts, fueled by the housing bubbles, especially in Spain and Ireland. On the other hand, the other countries- Germany, France, Austria and the Netherlands- were producers 'of first and last resort'  resulting in a growing surplus in current account balances, which was exacerbated by the strength of the euro. So, the large current account deficits, due to excessive consumption, led to loss of competitiveness and economic stagnation.

N. Roubini's argument points to the following option:  "Symmetrical reflation is the best option for restoring growth and competitiveness on the eurozone's periphery while undertaking necessary austerity measures and structural reforms. This implies significant easing of monetary policy by the European Central Bank; provision of unlimited lender-of-last-resort support to illiquid but potentially solvent economies; a sharp depreciation of the euro, which would turn current-account deficits into surpluses; and fiscal stimulus in the core if the periphery is forced into austerity". 

This solution is vigorously opposed by Germany and the ECB as it would have (modest) inflationary effects in core countries relative to the periphery. The bitter medicine that they are imposing on the 'peripheral' countries is deflation with recessionary effects: fiscal austerity, structural reforms and real depreciation. Austerity policies reduce output in the short term, due to lower demand and productivity effects linked to structural reforms and reduction of nominal wages and prices. This will become socially unsustainable, and if peripheral countries remain caught in a deflationary debt trap, they might be tempted to default and exit the euro area. In this scenario, "coercive restructurings of debt will come first, and then exits from the monetary union that will eventually lead to the eurozone’s disintegration".

Alternatively, the possibility of a break up of Europe, especially with Italy too big to fail or to save - and the contagion of the debt crisis to France, could lead to a closer political Union, which would require new forms of economic governance. The Netherlands Bureau for Economic Policy Analysis pointed out in a recent report that the debt burden of southern countries is not only the consequence of lax fiscal policies, but that  banks from the northern euro area have lent too much money to Greece and other troubled countries without any effective supervision in the banking system. It also believes all euro area countries should give up some national sovereignty when it comes to bank supervision, the EFSF, the deposit-guarantee scheme and budget supervision.

The German-French 'Directoire' no longer works and may be extended now to Italy - with the Monti government close to European affairs - with a view to build  more effective supranational institutions, in particular more economic powers to the ECB as a functioning lender of last resort, fiscal integration (with permanent fiscal transfers from the core to the periphery) and a common sovereign debt with the emission of euro-bonds. This project seemed unrealistic only a few weeks ago, now, with the opening of a strong divide with the UK and non euro-countries, it may even sound plausible in a few years time with a revised EU treaty.

P.S: Last week, José Manuel Barroso, President of the European Commission, warned that the collapse of the euro area would destroy half of the value of European economy, which would swamp the region to depression similar in scale to that of 1930. 

Seven Lies

Tell the Truth

Adam Smith wrote in his "Wealth of Nations"* (1776) : "the violence and injustice of the rulers of mankind is an ancient evil for which, I am afraid, the nature of human affairs can scarce admit a remedy. But the mean rapacity, the monopolizing spirit of merchants and manufacturers, who neither are, nor ought to be, the rulers of mankind, though it cannot perhaps be corrected may very easily be prevented from disturbing the tranquillity of anybody but themselves". The father of economic liberalism, who also was a professor of moral philosophy reckoned that although the economic system was profoundly unfair, there was little to do to correct the current state of affairs. The 'laissez-faire' can only be offset by wise behaviour of men. In fact, since its foundation, capitalism needs rules to limit and control the functioning of markets and the State has the responsibility to design these rules and to enforce them. For this reason, the current crisis is also a political crisis that we should understand as a crisis of the State as well as a moral crisis where ethical values are substituted by electoral promises.

Our political leaders should tell citizens that global crises require global, wide ranging solutions. They decide on limited, short term measures which will not allow us to get out from the current mess. They often lie to hide the gravity of the situation: most countries claimed that they had the most solid financial system and they end up saying that they need to recapitalize banks. But they avoid arguing about the true causes of the global crisis.

The G-20 summit in Cannes (3-4 November) was, in that respect, very disappointing given the high expectations raised , in particular on strengthening the international financial system . The final declaration is extremely vague: for example, it calls for a global strategy for growth and jobs and refers to a vague commitment to take "discretionary measures to support domestic demand, should economic conditions materially worsen" . In substance, the summit has failed to provide a coordinated response to the sovereign debt crisis and all big questions (for instance the financial supervision and regulation issues) remain unresolved. Moreover, it shows the inability of nations with different interests, and often ruled by political coalitions, to take collective actions to transform the rules and structure of the world economy.

In a speech held in September 2008, Sarkozy pledged " laissez faire is over (...) The financial crisis is not the crisis of capitalism. It is the crisis of a system that has distanced itself from the most fundamental values of capitalism, which betrayed the spirit of capitalism".He called banks to develop credit rather than speculation and limit traders' remuneration. In 2009 and 2010, despite joint calls with Merkel, little has been done to regulate the European financial market and ban high risk practices (derivatives, credit default swaps, short term selling, etc.) In August 2011, the aggression of financial speculation against sovereign debt shows that financial markets can still act freely, forcing European leaders to strengthen economic governance of the euro zone.

At global level, binding rules on capital requirements have been introduced for banks to limit their profits but in return they create an incentive to generate more profits, which restricts credits to enterprises. In the aftermath of the financial crisis in 1929, the Glass-Steagall Act introduced a strict separation between investment banks and commercial banks to regulate the US banking sector and avoid conflicts of interest and fraud. this provision was removed in 1999 (with a law signed by Bill Clinton !) which led to re-establishing conflict of interest in the financial sector and fostering 'too big to fail institutions' that led to the housing market collapse and the sub-prime crisis. Subsequently, heavily indebted banks were rescued without asking anything in return, no incentives to provide credit to the real economy and no ban on high risk financial activities.

Despite the gravity of the crisis and its consequences on the vast majority of citizens, most political leaders are still reluctant to introduce effective measures to tax the rich, ban tax havens or limit trading bonuses. Adam Smith wrote : "Wherever there is great property, there is great inequality". For the first time in the last two centuries, the new generations living in western countries do not have any hope of a better future than their fathers. They express discouragement and fear of being the victims of a historical regression in western civilization and values. They only have indignation to demand global change and put an end to enormous privileges of a tiny fraction of the population. But this is a legitimate fear that we must overcome if we are capable to return to genuine politics that the political leaders have lost, its capacity  to represent the interests of all, the profound aspirations and needs of the citizens to live in a better world. This is possible if they just start telling the truth.

* A.Smith. An Inquiry into the Nature and Causes of the Wealth of Nations. Ed. R. H. Campbell and A. S. Skinner. 2 vols. Glasgow Edition of the Works and Correspondence of Adam Smith 2. Oxford U. Press, 1976.

The primacy of Labour

In a recent speech held in Rimini on 28th October, Cardinal Bagnasco, a conservative and influential member of the Catholic Church, affirmed that the State has the duty to intervene to create job opportunities. He said: "”In the shadows of the non-working , confidence and self-esteem are severely threatened, and serenity to the future is not. For all these reasons, the State has the delicate and onerous duty to provide access to employment opportunities in different areas, taking into account all circumstances, however, that unusual, such as those that the world is experiencing, require an update of mentality and ability to ”renewal. (...) Without decent employment, the man hardly able to measure his personal capacity, to establish collaborative relationships with others, to contribute to the achievement of social good, to feel part of the building in the world, to perceive its dignity in earning honorable bread for themselves and their loved ones". 

The archbishop of Genoa has insisted on the work as " a right and duty of every person, the primacy of man at work, and the primacy of labor over capital, without labor". ”It‘s undeniable- he added – that all human activity, and then the work takes place within the culture and interacts with it, and then between economy and culture, there is a reciprocal relationship, but must remain firm and clear the primacy of culture, if you do not want to enter the jungle of a market without rules because without values.”

Every man  of good will and respectful of human dignity should subscribe to these words. In fact, many constitutions recognize that work is a right and its primacy over capital. This is the legacy of Europe's culture and ideas on labour and value developed by Adam Smith, David Ricardo and Karl Marx. 


Today's world is characterized by an increasing antagonism between labour and capital. Governments failed to address social inequalities while maintaining privileges for the rich. That unsustainable situation gave rise to the explosion of anger of the young generations and revived social conflicts in our societies. The Church's message on the priority of labour is a key component of its social doctrine and has been subject to academic discussion.  But now it has to be understood and turned urgently  into concrete measures of social justice and equity for the vast majority of men and women. 

The Icelandic lesson

In an international conference held on October 27 in Reykjavik, Iceland's experience in addressing the global financial crisis was reviewed. In the light of the achievements and challenges still ahead, there are some interesting lessons to learn in order to inform the wider economic issues for  the eurozone countries.

Iceland suffered the largest banking collapse in economic history. In 2008, the Icelandic financial crisis  led to the collapse of the three main banks, whose assets were much larger than the country's external debt. The national currency (krona) fell sharply (more than 35% against the euro) which led to capital account restrictions; the market value of  the stock exchange fell by more than 90%. This led to a severe economic recession, with a drop in GDP of 10,2% in 2009-2010. According to certain estimates, the cost of the crisis can be evaluated in  at least 75% of the country's GDP. But the external consequence was also dramatic as millions of  bank deposits were frozen and foreign banks had to face significant losses.

The government decided to nationalize the banking sector - which was deregulated in 2001 - (after that the UK decided to nationalize Bradford & Bringley, one of the banks involved in the financial crisis) since banks were unable to refinance their debts. Banks were restructured  and subordinated to stricter financial supervision; businessmen involved were subject to intense scrutiny; criminal investigations were launched on financial fraud. Eventually, the government resigned in 2009 after massive protests .

Since the crash, the country has improved its financial position and the economic recession was halted at the end of 2010. The emergency legislation which allowed the State to take control of the financial sector helped resolve the financial crisis.In fact, the country was not affected by Europe's sovereign debt crisis. Despite contention with Britain and the Netherlands over the question of a state guarantee on the deposits of an Icelandic bank (Landsbanki) in these countries, credit default swaps on its sovereign debt have steadily declined and are now much lower than Ireland . Furthermore, the decision of the government to apply for the euro membership has also helped to enhance credibility on international financial markets. 

But the most important fact is that a country on the verge of financial collapse has managed to resolve the financial crisis with a strong fiscal adjustment under an IMF programme while using the social welfare  system to maintain real wages. Welfare expenditure in the form of transfers to households and social protection increased significantly between 2007 to 2010 to soften the impact of the crisis. Child benefits were also increased and  targeted  at lower income groups. As a result the inequality trend was scaled back, with a Gini coefficient declining from 0,43, its maximum level in 2007 to 0,29. 


 European leaders should draw lessons from this country, in the way it managed to overcome the financial crisis with a sense of equity and justice. In comparison, the eurozone crisis requires urgent action on a much wider scale, including with non-European partners, and bolder measures to strengthen fiscal integration and the creation of eurobonds.

Nassim Taleb : The banks should be treated as Utilities

Nassim Taleb : The banks should be treated as Utilities