The whole point of medicine is tinkering with the way the body works. Aubrey de Grey

The wrong medicine

The Eurozone’s remedies against sluggish growth rates aren’t working. The problem: a misdiagnosis of the illness.

At the start of 2014 there was some hope that the economic recovery in the Eurozone would gather momentum. This hope has dissipated as the year has progressed. The slow growth in the Eurozone has become endemic since the start of the sovereign debt crisis in 2010, which contrasts the growth experience of the Eurozone with the non-Eurozone EU member countries. We observe the bifurcation in growth rates that occurred soon after the start of the sovereign debt crisis. As a result, economic growth in the Eurozone has tended to drop by 1.5 to 2% relative to the non-euro member countries since 2012.

What has happened since the start of the sovereign debt crisis that has led to a systematic divergence of economic growth in the Eurozone in comparison to the non-euro EU members?

The answer lies in the nature of macroeconomic policies pursued within the Eurozone. Since 2010, macroeconomic policies in the Eurozone have been dominated by two ideas: First, Eurozone policymakers took the view that the sovereign debt crisis should be fought by restoring budget balance as quickly as possible so as to stop the government debt accumulations. Second, in order to stimulate economic activity, structural reforms should be implemented, i.e. a series of institutional changes should be introduced, aiming at making the supply side of the economy more flexible.

Counterproductive reforms

It is now increasingly recognized that the first idea was based on a misdiagnosis of the debt crisis and that the second idea was based on an economic fallacy.

The misdiagnosis has consisted in thinking that the origin of the sovereign debt crisis was fiscal profligacy while it was in fact private-sector profligacy (with the possible exception of Greece, where it was both). Private profligacy led to excess private debt accumulation. After the bust, the private sector had to deleverage. The failure to recognize the nature of the recession, i.e. that it was a “balance sheet recession”, led the European policy makers to push national governments into austerity. As a result, both the private and the public sectors tried to deleverage at the same time. This introduced a deflationary bias in the Eurozone that led to a new recession in 2012-13 – the second one since the start of the financial crisis in 2007-8. Non-euro EU members, however, were spared from this second recession within a five-year time frame.

The structural reform programs that were forced onto many Eurozone countries were based on an economic fallacy that arose from the application of Say’s Law (or the law of markets), which postulates that supply creates its own demand. This led the European policymakers to believe that structural reforms that led to an increase in the capacity to produce (the supply) would automatically increase production. The latter did not happen. The main reason is that these structural reform programs were enforced while the same policymakers, through their austerity programs, did everything they could to reduce aggregate demand. No wonder output declined.

One of the most spectacular manifestations of these austerity programs was the strong decline in public investment in the Eurozone. After the sovereign debt crisis, the Eurozone governments, in the name of austerity, decided to dramatically reduce public investment. How they could hope that this would promote economic growth remains a mystery.

The correct policy mix would have been to institute structural reforms that increase long-term growth potential together with policies that stimulate aggregate demand. Unfortunately, policymakers were led astray by an economic fallacy (Say’s Law) that promised them that raising growth potentials would automatically raise production. At the same time, austerity programs, by forcing deleveraging on both the private and the public sectors, actually reduced production.

Germany must take the lead

All this leads to the question of what we should do today, in 2014. Governments of the Eurozone – in particular in the northern member countries – now face historically low long-term interest rates. The German government, for example, can borrow at less than 1% at a maturity of 10 years. These historically low interest rates create a window of opportunities for these governments to start a major investment program. Money can be borrowed almost for free, and there is great need in all these countries to invest in the energy sector, the public transportation systems, and the environment.

This is, therefore, the time to reverse the ill-advised decisions made since 2010 to reduce public investments. This can be done at very little cost. The country that should lead this public investment program is Germany. Public investments as a percent of GDP in Germany are among the lowest of all Eurozone countries. In 2013, public investment in German amounted to a bare 1.6% of GDP versus 2.3% in the rest of the Eurozone.

Such a public investment program would do two things: It would stimulate aggregate demand in the short run and help to pull the Eurozone out of its lethargic state. In the long run, it would help to lift the long-term growth potential of the Eurozone.

The prevailing view in many countries is that governments should not increase their debt levels lest they put a burden on future generations. The truth is that future generations inherit not only the liabilities but also the assets that have been created by the government. Future generations will not understand why these governments did not invest in productive assets to improve this generation’s welfare when they could do so at historically low financing costs.

Read more in this debate: Camilla Perfetti, Richard Koo, Ekkehard Ernst.


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