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Simon Wren-Lewis: The Root Cause of Europe's Depression


[W]hy are the US, and also the UK, undertaking austerity? The main argument is that government debt is too high. The Keynesian response is that this is the wrong time to be worrying about government debt. In a recession which is due to an increase in private sector saving, the government needs to run matching deficits to prevent output falling. For the world as a whole, if government deficits come down, private sector surpluses must fall to match. Normally monetary policy would encourage the private sector to save less by lowering real interest rates. However in many countries the monetary authorities have already lowered nominal rates (almost) as far as they can…. Advocates of austerity argued that reducing government debt would encourage private spending by boosting confidence. This was always an argument of hope over both theory and evidence, as the last two years has shown….

This argument against austerity now is quite compatible with a view that government debt is much too high from a longer term perspective. It is all about choosing the right time to deal with that problem….

[F]iscal policy in the Eurozone as a whole seems particularly misguided. Overall government deficits as a share of Eurozone GDP are much lower than in the US or UK, yet the speed of fiscal consolidation is more rapid in the Eurozone…. The story told by many is that the Eurozone crisis is a result of fiscal profligacy in some countries, and the need to put that right quickly because of market pressure. This account misses two essential underlying causes…. The first missing element is competitiveness…. [B]efore 2008… private sector demand [in southern Europe] was too strong, encouraged by large capital inflows from abroad and real estate bubbles.

Here again a classic Keynesian perspective is instructive. In a monetary union, fiscal policy has to take on a major countercyclical role in response to large idiosyncratic shocks…. [B]y ignoring countercyclical fiscal policy, the SGP encouraged governments in periphery countries to allow a growing loss of competitiveness to persist. In that sense, ignoring basic Keynesian ideas helped cause the Eurozone crisis.

The second key feature of the current crisis is… a banking crisis. This, rather than fiscal profligacy, was the major cause of the crisis in Ireland, and likewise in Spain….

[T]here was, and still is, a very simple and effective solution to the immediate Eurozone crisis, and that is for the ECB to undertake a programme of Quantitative Easing (QE) focused on markets where interest rates were inappropriately high…. The main reason this has not been done by the ECB appears to be a concern about moral hazard: that without market pressure, governments would lose their incentive to undertake austerity and structural reforms. (There is also a concern about ECB balance sheets, but this just seems to misunderstand what a central bank is.) There are two quite reasonable responses to this concern. First, in a crisis, moral hazard concerns have to be put on one side, as central banks recognise in a financial crisis. The fire engine does not drive slowly to the fire to encourage others to be careful. Second, data on underlying primary balances clearly shows that all periphery governments have already undertaken a massive amount of austerity.

These moral hazard concerns are misguided for a more fundamental reason: they misdiagnose the key problem as public rather than private sector profligacy….

The essential problem is lack of competitiveness outside Germany. Although this requires deflation, there are two simple reasons why it should be gradual rather than sharp. The first is the Phillips curve: gradual deflation to adjust the price level is much more efficient. The second is aversion to nominal wage cuts, which makes getting significant negative inflation very costly….

Why does this simple logic continue to be ignored by Eurozone policymakers? There was a fear when the Eurozone was set up that allowing countercyclical fiscal policy would lead to deficit bias…. This last point now seems a little ironic, as we currently have too much market discipline. Yet the focus on government profligacy effectively meant that governments ignored the possibility of private sector profligacy, which turned out to be the greater problem….

There is an underlying pattern behind Eurozone policy errors. They reflect a view that macroeconomic difficulties are primary due to bad government decisions, while private sector decisions within a free market environment do not create problems. Whatever label we want to give this view (Ordoliberal or Anti-Keynesian), it is the fundamental cause of the current Eurozone crisis. Its persistence despite all the contrary evidence allows the crisis to continue and threatens the integrity of the Eurozone itself.