Monday, May 16, 2011

Europe and “Hard Keynesianism”

The financial troubles of Greece, Ireland, and now Portugal have been well publicized. Besides providing funds to bail these countries out over the short term, other members of the EU have imposed severe cuts in government spending. The philosophy was to placate debt holders and instill confidence that these governments were on a sound fiscal path. The debt holders were not convinced. They were smart enough to know that government austerity in a time of recession is never a good idea. They also seem to fear for the sustainability of the governments themselves under the political pressure the austerity has generated. The result has been low economic growth, increasing unemployment and increasing costs for new debt.

Henry Farrell and John Quiggen have written an article for Foreign Affairs titled How to Save the Euro—and the EU. They have included the subtitle: Reading Keynes in Brussels. These authors argue that the EU, driven by Germany and, to a lesser extent, France, is imposing an economic regime on itself that can only lead to disaster.

“But as many economists have pointed out, these measures are hindering growth without satisfying bondholders that their money is safe; bondholders worry that these measures are not politically sustainable. In fact, they are likely to undermine Europe's political union.”

“Nevertheless, Germany has been pressing European countries to institutionalize more stringent cuts in spending. In February, it, along with France, proposed that members of the eurozone introduce "debt brakes," inflexible limits on deficit spending. Germany had already incorporated such a cap into its own constitution, one that severely restricts any government deficit spending, including the kind that might benefit the country's long-term growth. In early March, the other 16 eurozone states agreed to introduce such debt brakes or some equivalent into their domestic laws and to make them as durable and binding as possible, for example, by incorporating them into their national constitutions.”

The authors believe these “debt brakes” are so stringent that the various countries will be unable to spend sufficiently in a downturn to counter its effects. The result will be what Greece faces. The only way to control debt with declining growth is by cutting back on wages and services. In other words, the governments are asking their voters to suffer the consequences. The authors point out that, historically, that has never provided a path towards political stability.

Instead, they claim that the proper path is not to eschew Keynesian economics but to embrace it in its true form—“hard Keynesianism.”

“Contrary to the beliefs of nearly all anti-Keynesians -- and, regrettably, some Keynesians, too -- Keynesianism demands more, not less, fiscal rectitude in normal times than does the orthodox theory of balanced budgets that underpins the EU. John Maynard Keynes argued that surpluses should be accumulated during good years so that they could be spent to stimulate demand during bad ones. This lesson was well understood during the golden age of Keynesian social democracy, after World War II, when, aided by moderate inflation, the governments of the countries in the Organization for Economic Cooperation and Development greatly reduced their ratios of public debt to GDP.”

While it is a good idea to discourage deficit spending, it is foolish to eliminate it as a part of fiscal policy when there is a compelling need to supplement demand. The authors contend that nations are weak willed and will squander riches and run small deficits even in the best of times. The appropriate legislation should focus on deriving enforceable rules that would require nations to save resources in the good times to pay down debt or to use to stimulate the economy when necessary. This would not be a simple or easily attained goal.

“Resorting to hard Keynesianism to deal with the euro crisis would require making far-reaching changes to the rules and practices of the EU's economic and monetary union. It would mean both toughening the requirements of the Stability and Growth Pact, which governs the euro, and strengthening the enforcement of these rules. As they stand, the Stability and Growth Pact's bylaws require the eurozone states to maintain budget deficits under three percent of GDP and debt-to-GDP ratios under 60 percent. The system does not provide enough flexibility during downturns: even German politicians ignored these requirements a few years ago, when Germany was suffering from a recession -- much as they prefer not to remember this today.”

“To be more effective, the system needs to be stricter. The Stability and Growth Pact should be strengthened so that it requires countries to put aside surpluses during auspicious years. Since governments are persistently tempted to squander surpluses, a new supervisory institution should be introduced at the EU level. It should be granted access to detailed budget-planning and other economic information from the eurozone states and should be empowered to sanction misbehaving states.”

This issue appears to be one component of a perfect economic storm that must push the EU to greater integration if it is to continue to function.

The authors finish their argument with this warning.

“By concentrating on its economic problems but ignoring their political consequences, the EU is setting itself up for failure. The case for austerity does not make sense. And if the EU fails to deal with the political fallout of its own institutional weaknesses, it is going to collapse. No political body can force voters to repeatedly shoulder the costs of adjustment on their own and expect to remain legitimate....Hard Keynesianism offers a means to combine fiscal discipline with flexibility in order to cushion the political costs of adjustment in times of economic stress. EU leaders must institute it in a hurry.”

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