Austerity has brought Europe to the brink again

By Lawrence Summers
April 30, 2012

Once again European efforts to contain crisis have fallen short. It was perhaps reasonable to hope that the European Central Bank’s commitment to provide nearly a trillion dollars in cheap three-year funding to banks would, if not resolve the crisis, contain it for a significant interval. Unfortunately, this has proved little more than a palliative. Weak banks, especially in Spain, have bought more of the debt of their weak sovereigns, while foreigners have sold down their holdings. Markets, seeing banks holding the dubious debt of the sovereigns that stand behind them, grow ever nervous. Again, Europe and the global economy approach the brink.

The architects of current policy and their allies argue that there is insufficient determination to carry on with the existing strategy. Others argue that failure suggests the need for a change in course. The latter view seems to be taking hold among the European electorate.

This is appropriate. Much of what is being urged on and in Europe is likely to be not just ineffective but counterproductive to maintaining the monetary union, restoring normal financial conditions and government access to markets, and re-establishing economic growth.

The premise of European policymaking is that countries are overindebted, and so unable to access markets on reasonable terms, and that the high interest rates associated with excessive debt hurt the financial system and inhibit growth. The strategy is to provide financing while insisting on austerity, in hopes that countries can rein in their excessive spending enough to restore credibility, bring down interest rates and restart economic growth. Models include successful International Monetary Fund programs in emerging markets and Germany’s adjustment after the expense and trauma of reintegrating East Germany.

Unfortunately, Europe has misdiagnosed its problems in important respects and set the wrong strategic course. Outside of Greece, which represents only 2 percent of the euro zone, profligacy is not the root cause of problems. Spain and Ireland stood out for their low ratios of debt to gross domestic product five years ago, with ratios well below Germany’s. Italy had a high debt ratio but a very favorable deficit position. Europe’s problem countries are in trouble because the financial crisis under way since 2008 has damaged their financial systems and led to a collapse in growth. High deficits are much more a symptom than a cause of their problems. And treating symptoms rather than underlying causes is usually a good way to make a patient worse.

The cause of Europe’s financial problems is lack of growth. In any financial situation where interest rates far exceed growth rates, debt problems spiral out of control. The right focus for Europe is on growth; in this dimension, increased austerity is a step in the wrong direction.

Systematic comparisons suggest that when economies are demand-constrained and safe short-term interest rates are near zero, policy measures that reduce the deficit by 1 percent have a multiplier of 1 to 1.5 – implying that a 1 percent reduction in a country’s ratio of spending to GDP or an equivalent tax increase reduces its GDP by 1 to 1.5 percent. Essentially, cutting deficits will have a disproportionately adverse effect on GDP because the multiplier is larger than 1 on the growth-reduction side of the equation. This means that austerity measures at the national level are likely to be counterproductive in terms of creditworthiness. Fiscal contraction reduces incomes, limiting the capacity to repay debts. It achieves only limited reductions in deficits once the adverse effects of economic contraction on tax revenue and benefit payments are accounted for. And it casts a shadow over future growth prospects by reducing capital investment and raising unemployment, which inevitably takes a toll on the capacity and willingness of the unemployed to work.

These considerations are magnified at the continental level. Slowdowns in one country reduce the demand for the exports of other countries. As a matter of arithmetic, increases in saving and exporting in some countries have to be offset by increases in spending and importing in others. Germany’s enormous success in recent years has been achieved by becoming a large-scale net exporter – it would not have been possible without large-scale borrowing and importing by Europe’s periphery. The periphery cannot possibly succeed in substantially reducing its borrowing unless Germany pursues policies that allow its surplus to contract.

Skeptics will rightly wonder how a prescription for more spending by countries that already have trouble borrowing can be correct. The answer lies in the difference between borrowing by individuals and countries. Normally, an individual helps his creditors by borrowing less; but a person who stops borrowing to finance commuting to his job does his creditors no favor. A country’s income is determined by spending, so a country that pursues austerity to the point where its economy is driven into a downward spiral does its creditors no favor. Yes, there will ultimately be a need to raise retirement ages, reform sclerosis-inducing regulations and restructure benefit programs; phased-in commitments in these areas would be constructive. But the prospect for political and economic success in these endeavors depends on growth being restored.

Only if growth is restored can the euro endure and European financial problems be resolved. If there was ever a situation that called for a collective response, this is it. Going forward, the IMF and international community should condition further support not merely on individual countries’ actions but on a common European commitment to growth.

PHOTO: European Central Bank (ECB) President Mario Draghi addresses the European Parliament economic and monetary affairs committee in Brussels, April 25, 2012. REUTERS/Yves Herman

19 comments

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There’s more to it than just another rematch of Keynes vs Hayek. There’s no ring in the eurozone to hold the match. There is a currency, the euro, and there’s an institution whimsically called the European Central Bank, but there’s no nation associated with either. Hence, no corresponding national budget, and no authoritative place to even discuss the pros and cons of either stimulus spending in hard times or surplus accumulation in flush times. There are 17 no-longer-sovereign political entities that are not united by anything, except a currency in search of an actual sovereign.

Posted by TobyONottoby | Report as abusive

If Mr. Summers’s views have been not only repeatedly wrong,and extraordinarily destructive, it is amazing that anyone would consider his opinion. Everyone gets it wrong at times, especially economists, but most of us are not allowed to keep our jobs if we are mostly wrong. Amazing.

Posted by no1ego | Report as abusive

With a country like spain, where gov expenditures come higher than entire united states, where no money is spent for education but only in latin america instead of spain itself (see mayor Laorden Carrasco, Blanca , Murcia congratulated by queen, while in his own village only crisis , and if that was not enough , mayor extortionate those who claim for legality , ref case Perpen, after 10 years asking for licence to build, finally got one paid it and sees construction paralysed ! Electricity refused while mayor used that property t instal electric outline to provide village !!! Etc. a mayor who makes more money than he should for ge can decides how much he wants!!! Thanks to spanish gob, and the queens and king refusing to respond about how her daughter stole 1000 s of millions from citizen to build a mere palace., I think if they were put in jail, that would clear much of their crisis

Posted by Mcp4 | Report as abusive

“The cause of Europe’s financial problems is lack of growth.”

Wrong!

The cause of lack of growth is continuing to bail out the banks, who then use the money for their own purposes, so that none of it reaches the street where the people need the money.

Thus, there is no demand and the economies are rapidly failing.

The US has EXACTLY the same problem.

As a result, the US will soon have the same economic problems that the eurozone has at present.

The crisis point will likely come with the arrival of 2013, which is when all those delayed austerity measures already passed finally hit the US economy.

Posted by PseudoTurtle | Report as abusive

the problem is that the preferred course of action in both the U.S. and Europe seems to be to kick the can down the road. The time to reform retirement ages, regulations, benefit programs and the like is NOW, not some nebulous time in the “future”. Having the government provide more “stimulus” without making any reforms will just make the required reform even tougher to achieve as more of the population gets used to receiving handouts via the government. If the markets saw that real reforms were happening, companies would be able to raise capital to grow their businesses, more people would be hired, and efficient economic decisions would be made in the private sector, not by politicians who can’t help but be swayed by various “special interests.”

Posted by USA4 | Report as abusive

@ USA4 –

You are completely and totally dead wrong!

Social Security is NOT the problem.

The government has spent the Social Security Trust Funds, which is why it is presently broke. They used the funds to support other spending they could not have funded otherwise. Now, with the economy in tatters, there is not enough revenue coming in to pay for both Social Security and the other “sacred cow” programs (e.g the Military/Industrial Complex), so they are desperately trying to renege on paying their legal debt to the American people who paid into Social Security from wages throughout their entire lives (and not by choice).

———————

The markets are doing just fine — but the real US economy is dying — thanks to continuing bank bailouts, which are used by the wealthy to invest in third-world countries to provide jobs there, instead of in the US economy which desperately needs those jobs.

Government mismanagement of the Social Security Trust Fund for decades, along with greed by the wealthy who are now in control of the government are the real problems in the US economy.

You need a SERIOUS reality check on what is going on!

Posted by PseudoTurtle | Report as abusive

In the Utopian Free Market (such as the one inferred by USA4), there is no need for regulation and taxes, because everyone is always confident that the markets will never fail.

And Capitalists and Conservatives have issued a Free Market Revised Bible, in which Matthew writes:

“Blessed are the filthy rich, for their Gold is waiting in the kingdom of Heaven.
Blessed are they, who desecrate our dead enemies, for they shall be celebrating in the streets with Southern Comfort.
Blessed are the bold, for they shall enslave the Earth.
Blessed are they who used justice for their own means, for they shall profit.
Blessed are the merciless, for they shall be strong (and Win!)
Blessed are those with cleaned paper trails, for they shall never see prison.
Blessed are the war-mongers, for they will be called the missiles of God.
Blessed are the torturers, for theirs is the solace of hearing screams of pain.”

Posted by GRRR | Report as abusive

@ GRRR –

Thanks for making my day!

Have a good one yourself.

Posted by PseudoTurtle | Report as abusive

The summer wind, came blowin in- from across the sea
It lingered there, so warm and fair – to walk with me…

Oh Lar. If only the capacity and the willingness of the unemployed to work would be unleashed by the common European commitment to growth. Achtung baby. Why ain’t them folks with all that capacity to do that work simply a workin harder? Unleash ‘em!

Print. Print. Print. Larry’s banksters delight. ECB to da banks to da guvments to da euro back to da ECB and IMF.

Larry, the “growth” is right there in front of you. It’s just not the kind of growth means anything.

Posted by jimfin | Report as abusive

From the start, it had been clear that the Eurozone’s economic meltdown resulted from structural dysfunctions rather than short-term deviations from equilibrium that could be fixed by routine economic stabilization measures like fiscal austerity and quick-fix “quantitative easing”. Larry Summers is perfectly right that a collective, non-dissonant commitment to growth by ALL members of the Eurozone is what is required tosave the common-currency regime. The real question that Larry does not address is : what are the tools available to achieve that growth, which will have to be intensely job-creating in nature. Evidently, what the flailing European economies need is not just short-term funding, but several phased episodes of disbursements of fresh funds while it GRADUALLY restructures the macroeconomy and the mesoeconomy (that is, while it carries out structural adjustment and sectoral adjustment) to refurbish its manufacturing base to higher-quality industrial output that also creates employment. Simultaneously these countries would need to overhaul their tax structure to generate the revenues to repay mounting debt.

The “Argentine solution”of the write-off of a critical mass of Eurozone debt by the commercial banks (either through pro-rata defaults by each Eurozone country or by a select group f debt-distressed countries) is a non-starter, because it is mainly Eurozone banks that are exposed to the non-performing debts. The ECB and EFSF (European Sinancial Stability Fund), for their part, do not have the reserves to meet the financial means to tide the distressed Eurozone countries over the short and medium terms to stimulate growth. And just “prining money” a la Greenspan won’t work, either because confidence in the Euro would plummet further. The IMF also does not, as of now, have the resources to finance the pro-growth structural adjustment programmes that the Euorzone countries will need to get out of the morass. It has been said before and it needs to be repeated : the only way for the IMF and the EFSF (European Financial Stabilization Fund) to obtain the 2-trillion dollar-size funds that is required to do the job is to open up the paid-up and callable capital base of the IMF and secure related loanable funds from China, Brazil and West Asia to the EFSF and in return give them more voting power and influence in the IMF and related multilateral financial institutions. If, in the G20 meeting in June, the G8 group of countries implement this inevitable act of financial sanity, the world will be saved. Otherwise, let each country, within the Eurozone and outside it save its own skin as best it can.

Posted by MohamedMalleck | Report as abusive

“The cause of Europe’s financial problems is lack of growth.”

Really? Let’s take a look at the numbers. These are the 2011 GDP growth figures of the eurozone countries and the US.

Take a good look. Compared to the eurozone countries, the US is slightly below average. Much better than the worst (Greece), and much worse than the best (Estonia).

Data taken from the CIA World Factbook.

Estonia 6.5
Luxembourg 3.6
Austria 3.3
Slovakia 3.3
Finland 2.7
Germany 2.7
Malta 2.5
Belgium 2
France 1.7
Netherlands 1.6
United States 1.5
Ireland 1.1
Slovenia 1.1
Spain 0.7
Italy 0.6
Cyprus 0
Portugal -2.2
Greece -6

Posted by jmitch | Report as abusive

I concur with USA4. The US is a capitalist society, driven by small business. It is completely different from Europe in how it functions.

People can’t figure out how to get out of the current problems because they are looking at the economy, which is the symptom not the problem. The main problem I see today is that the education system and society in general have been deceived by false theories about how the world functions. We teach kids to expand their horizons, but not how to calculate; people vote based on ideas that have no basis in reality and don’t seem to want to question anything – only accept whatever the media presents. We need to apply ourselves to healing our society (the economy will follow). The bill for decades of dreaming is coming due in a harsh reality.

As to the rich, people seem to forget that George Washington was one of the richest men in the Colonies, as were members of the Continental Congress. Such were the people who provided freedom to the land. The result of hard work is wealth (if the government doesn’t take it first). That is not a bad thing, it is capitalism. The American people can find a way forward if they remain true to the concepts that built the country. That is not to say that we should not “buy American”, or that people should outsource jobs. It is to say that we need to find ways to embrace and enhance what made the country great rather than argue over wealth.

I would also like to point out that the US Government has no legal obligation to pay anyone anything out of Social Security. The US Supreme Court (in it’s rulings back in the 1940′s) clearly stated that the money provided to SS belongs to the US Government and not to the individual who paid into the system, and that it can spend it any way it desires. It is only politics that keep it “reserved” for retirees and others. I myself learned this very recently.

Posted by stevedebi | Report as abusive

Essentially what is needed is economic activity. But what could the source of that economic activity be? The public sector – as the author wishes? Or the private sector?

More economic activity could be generated by the private sector in the EU and USA if their goods were more competitive in international markets. But they are typically not competitive, because goods made in China are cheaper, thanks to China’s currency manipulation.

This situation is highly profitable for the large international corporations who manufacture in China, but disastrous for the industrialized economies as a whole. And it is plainly unfair.

So how could the EU and USA stimulate the private sector? By insisting that China allow its yuan to float freely, as other major currencies do.

If allowed to float freely, yuan would rise to a fair level, and jobs would come back to the EU and USA. The resulting higher personal incomes would yield greater tax revenues, and hence lower national debt levels.

Wake up Europe and America! Time is running out!

Posted by DifferentOne | Report as abusive

“The cause of Europe’s financial problems is lack of growth”

The bail outs only prevented the banks from failing.
The unemployment went up, gas prices went up and housing suffered. Tax revenues took a big hit, but governments did not cut back fast enough and the socialist program costs soared to support the ever increasing
unemployeed. A vivious cycle emerged.

The solution is hard to hear, but hear it goes. Europe and the USA is overpopulated. There is not enough jobs to support the population. Factories are too automated and the Asian and Latin economies allow dirt cheap labor and will never return. The jobs will not come back, so we have to start enforcing the borders and start throwing out the freeloaders. This is hard for leftist groups to fathom, but the truth is sometimes painful, but we need to take care of our own. We have been too soft for too long. Our bleeding hearts have spread to every orifice of our body and we are in danger of bleeding out.

Posted by EagleDriver | Report as abusive

“Austerity has brought Europe to the brink again…”

No, actually running a steady stream of deficits brought Europe to the brink. Austerity is a late entry and a distant second to the actual cause. Tough to be a Keynesian in a world where the chickens have come home to roost.

Posted by ARJTurgot2 | Report as abusive

Wow…the world’s top economic experts have all gathered here…for no use.

The EU & USA are gone, collapsed, finished,
…China, here I come….

Posted by GMavros | Report as abusive

What Europe needs at the moment are ‘statesmen’ NOT politicians. ‘Statesmen’ lead for the next generation, while ‘politicians’ look at only the next election. The Euro Currency was flawed from the start — a currency union without any central fiscal union and inviting too many players of different condition at the start of the game. So how to save a good concept from going bad?? Implement fiscal union – central monetary authority, mutualization of soverign debt, central settlement … remove player that are not fit to play … and do it decisively!!! Seems LS contribution to the debate between austerity and growth is meaningless … since both approaches just treat the symptoms not the underlying cause. LS is right, the patient will get worse, but under both a growth or austerity treatment. To treat the cause of the patients illness Europe needs to quickly implement measures for a fiscal union. Is LS a ‘statesman’ or just another ‘polotician’??

Posted by youyi | Report as abusive

Europe has too many people claiming to be hard up, unwell, lazy etc.

I think huge cuts need to be made in government expenditure, to allow room for the private sector to crowd in.

Take the example of a regional administrator or customs official. They waste thier time on administrative tasks. The offices are sleepy and unproductive. Or worse, thy are paid to sit at airports and check people’s bags. What a life, eh

If they where released from thier jobs, they might accomplish great things, open a business, provide a service, become a specialist etc.
Same for all the people on benefits. remove the benefits and suddenly, they need to prod

Posted by Anonymous | Report as abusive

See, if you look at all the past crisis, tequila crisis, Asia crisis, and mire recently USA and Europe. The causes are the same.

Deficits above 5% of GDP, debt above 60% GDP. The problem is the deficit and the debt, not the lack of governor spending.

They where also often characterized by current account deficits. Spendingloans for example on imports from China. Example, government pus pensionr, and borrows money to pay social security. Pensioner buys cheap clothing from China. China turns around and lends money to the government which they promise to pay back with interest.

Government in europe / USA becomes the debtor, China the creditor.

Debtor is servant to the creditor. Now we have Asian companies buying European companies, banks etc.

Posted by Anonymous | Report as abusive