A Panacea for the Eurozone Problems

13 December 2014

A Panacea for the Eurozone Problems?

Concern about the stagnation of economic growth in the Eurozone is again growing. Unemployment is still unacceptably high in a number of the Eurozone countries, notably Italy, Spain, Greece, Portugal, and Ireland. At 0.3% the rate of inflation is well below the mandated rate of just below 2% and fears of deflation have not gone away. The latest ECB growth forecasts are for 0.8% in 2014 and 1.0% in 2015.

The ECB, still holding its benchmark interest rate at 0.05%, was expected by some commentators to be ready to launch its variant of quantitative easing (QE) before Xmas, and is more widely expected to pursue this last shot in its monetary policy locker in the New Year. However, this will be vehemently opposed by Germany and Jens Wiedmann, the Bundesbank representative on the Governing Council of the ECB will certainly vote against such an intervention.

It is argued that QE – essentially purchasing sovereign bonds from banks – has been operated successfully in the US and the UK in that growth in these two countries has recovered. (QE in these countries is now being slowly unwound). In fact, it is debatable – apart from creating asset price inflation and depressing the exchange rate – whether it is QE which has between responsible for the growth in the US and in the UK. In both cases, demonstrably in the US, and covertly since 2012 in the UK, fiscal easing has been the major cause (aided by a low interest rate) of the economic growth.

If this argument, now becoming accepted by many economists, is correct then if the ECB moves to QE – and does not also ease the still tight fiscal austerity within the Eurozone, economic recovery is not likely to occur. The opposing argument, mounted by Germany and the fiscal hawks in the European Commission, is that the fiscal austerity is necessary to achieve the structural reforms in the peripheral economies, and in Italy and France. It is further argued that is only these structural reforms which will secure the required economic growth. The recent emergence of, albeit slow, growth in Spain is advanced to prove this proposition.

In fact, Spain is not a good example. The economic problems in Spain were concentrated in an over-developed construction industry stimulated by an over-blown domestic and commercial property boom, supported by massive over-extension of politically influenced regional banks. Much of the rest of the Spanish industry and commerce, e.g. pharmaceuticals, was strong and has continued to develop. However, less fiscal austerity would have enabled a faster Spanish recovery, with less unemployment and social misery.

So what is required for the Eurozone to be restored to economic health.

First, no-one would wish to deny the need for structural reform in labour, capital, and product markets in a number of the Eurozone countries. This is an on-going process which will best take place in a growing economy, rather than a shrinking one. The quaint, and dangerous, moralistic view, propagated by Germany, that only unpleasant medicine will work is precisely that, quaint and dangerous.

Second, the Fiscal Compact should be interpreted intelligently. Returns to budgetary balance should be postponed to enable fiscal expansion to stimulate the economic growth which will, of itself, reduce deficits. It is unbelievable that all the available historical evidence, supported by monetary economic analysis, suggesting that budgetary surpluses are a rarity is ignored. The US economy, for instance, has had only seven short periods of budget surpluses since 1776, most of which were followed by recessions.

Third, it would be sensible for the Eurozone not to emulate the dysfunctional German approach to economic growth, reliant on damaging, to other countries, substantial and persistent net export surpluses. Unfortunately, the global problem of permanent trade surplus countries, identified as requiring remedial action via the ‘hard currency’ clause in the IMF constitution, has never been tackled. However, as the exacerbation of the Eurozone financial crisis, by German export surpluses, stimulated by substantial pay restraint  and hence low export prices, demonstrated, such surpluses are damaging not virtuous. One can have too much of a good thing!

Unfortunately, whether the above move to a virtuous cycle will happen is less likely than that the Eurozone economic stagnation will continue for some time: damaging not only to the Eurozone countries, but also to the wider EU, including the UK. 

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