Pitfalls of Austerity Part I: A Misdiagnosed Crisis

Yesterday the European Commission gave its annual recommendations for the member states’ economic policies. Barroso said, that “Europe must move beyond the crisis.” Policy proposals focus on growth, rather than austerity, allowing several member states to take more time to cut their deficits. The EU’s executive celebrated the reduction of countries suffering from severe deficits from 24 to 16 since 2011, calling on Germany to consider wage increases to boost domestic demand. Wow, it seems like the crisis is about to pass! Of course, at the same time the OECD reduced the eurozone’s growth forecase to -0.6% this year, down from -0.1% six months earlier.

Barroso seems lost

The Commission is panicking, and it has got every reason to. The EU’s strategy to combat the crisis is failing, and calling the Commission’s proposals “a shift from austerity,” as EurActiv does, seems almost cynical. Giving the member states a few extra years to cut their deficits cannot seriously be called a policy shift, particularly as the proposal is met with resistance from the EU’s largest member state. Austerity should not be weakened a bit, as this would mean a mere extension of the policy – it has to be abandoned altogether. It is 2013, and austerity has been in place for four years without success. It seems necessary to spell out once more why austerity is a misguided, dangerous and hopeless policy that will lead Europe into an abyss that it might not recover from.

This post is the first of a series of blog posts discussing the fallacies of austerity. It draws heavily on an article by Robert Boyer on the subject. One of the major reasons for why austerity cannot work is because it is based on a false diagnosis of the roots of the crisis – Europe’s policy-makers are administering antibiotics against a virus. The underlying assumption behind austerity is that the crisis is caused by irresponsible public spending, when it has really the result of a private credit boom in the US.

The deregulation of the banking sector in the 1980s allowed for toxic subprime loans to be securitized by mixing them with high quality loans. It was thought that this would spread out the fallout risk of these loans to a minimum, allowing for a surge of private lending to the poorest fraction of Americans. Banks felt relieved of the responsibility related to the need for the careful selection of their debtors, and the real estate bubble was allowed to grow. The untaxed free global trade with financial products enabled these loans to be spread out to Europe in particular, and when the bubble burst, several EU member states became afflicted with excessive debt burdens as a result of having to bail out their ruined banks. The crisis is not the result of irresponsible public spending, but of a deregulated financial market. Spain even ran a budget surplus before the shock of 2008 as a result of its own booming real estate market.

Underlying Causes of Financial Deregulation

Growing inequality in the US in the late 20th century

The story of the crisis begins after WWII. Keynesian policies were adopted, allowing for a steady and sustainable growth pattern in the capitalist world over the post-War decades. Productivity and the mean incomes per household were rising. In the US of the late 1970s, the increase in productivity began to slow down, causing the wages for low-skilled labour to stagnate. Wages for in the services sector and in the high-tech industries on the other hand continued to increase, initiating the growth of the income gap. Initially governments were able to compensate for this trend by the establishment of extensive welfare systems, which were based on the solidarity of those with high salaries. In the 1980s, this assumed solidarity was quickly met with resistance, and governments began to finance their welfare system with cheap credit from their central banks. This caused public debt to grow radically. Public debt may thus be seen as the attempt to states to balance out the rising inequality in their societies.

The increasing importance of the financial sectors was due to the rising dependence of governments on debt, as well as to the use of the financial industries to compensate for the slowing growth figures of the manufacturing sector. Economic growth and high public spending could only be sustained by innovation in the financial sector – the deregulation of the financial ‘industry’ was seen as the most effective method to ensure its continuing growth. It is that deregulation that ultimately allowed for the emergence of the financial crisis of 2008 which triggered the implementation of austerity policies.

Structural Problems within the Eurozone

Polarization of trade surpluses/deficits in Europe

The finance-based growth of the post-1970s was exacerbated in Europe by the introduction of the euro. The introduction of a common currency under strict anti-inflationary regulations disallowed the member states from devaluing their currencies. When the euro was designed, policy-makers did not think of a compensating mechanism for this problem, and it was assumed that the price transparency linked to the common currency would drive the participating economies to convergence. Reality was quite different. Even before the introduction of the euro banknotes in 2002, the eurozone had begun to divide. Still faced with the effort to compensate for the rising inequality within their societies, the member states adopted different strategies to finance their welfare systems without increasing exports by devaluing their currencies. Germany adopted a deflationary low-wage policy, which has the same effect as a currency devaluation. This drove up Germany’s exports. Having no strong manufacturing sectors of their own, other member states focused on an imaginary credit-led growth, leading to the vast growth of their financial industries. When the real-estate bubble burst in 2008, these countries were particularly vulnerable.

Austerity is Fighting the Wrong Malady

The myth of irresponsible public spending is extremely superficial, and falls apart upon a minimum of close examination. As long as the European Commission does not fundamentally change its discourse and its policy recommendations on the crisis, Europe cannot recover. The re-regulation of the financial markets, and the establishment of a permanent European solidarity mechanism is of paramount importance to economic recovery and to the success of European integration. Austerity is not only destroying the economy, but it is translating the economic divisions of Europe into the hearts and minds of Europe’s citizens.

Harald Köpping

Also read: Boyer, R. (2012). The four fallacies of contemporary austerity policies: the lost Keynesian legacy. Cambridge Journal of Economics. 36. 283-312.