No End to the Panic

(The Global Crisis in Confidence, 25 Jul 2012)

Dan Baker ·

Rushing from one brush fire to the next with a leaky bucket, the European reaction to its sovereign debt crisis has been long on panic and short on comprehensive solutions.  Rightly intent to prevent a Lehman-Brothers type contagion, but also hesitant to overreach politically, European leaders have followed Germany through a muddled reaction.  Each new measure has been more strained than the previous.  As of writing, the Euro leaders have staved off the existential threat, but have accomplished little else.  Survival may be essential, but there also must be critical examination of the piecemeal strategy to return to economic stability.

While bailing out the periphery, the Euro core has extracted liberalizing reforms, program cuts, and covenants on deficits with intent to make the periphery leaner and more competitive.  It stands to reason that with a more more competitive economy and smaller deficits, they would be more able to shoulder the burden of their debts.  Perhaps more importantly to the political leaders involved, the covenants are designed to prevent a moral hazard in running up another large debt before asking again for a bailout.  On first examination, consolidation is a natural, instinctual reaction to a crisis, and it will gain a lot of votes from the common-sense critics in an electoral base.  However, on closer examination, it gives rise to more questions than answers.

Of course, increased competitiveness and smaller deficits help any economy, but these are only part of the story.  The sovereign debt crisis arises under the auspices of a severely depressed European economy that many economists expect to suffer a double-dip recession in 2012.  That double-dip has seemingly been caused by the debt crisis or the reaction to thereto, and the issues must be understood and solved together.  Solving the debt crisis while remaining in depression is both unacceptable and infeasible, as a suffering economy naturally reduces tax revenues and increases welfare expenditures, each making sovereign debt balance more difficult to sustain.  In fact, Olivier Blanchard, chief economist at the International Monetary Fund, recently suggested that joint fiscal consolidation, such as the reforms enforced in Europe, may actually make a sovereign debt crisis worse, as its negative effect on growth is so profound that it overwhelms the costs saved. [1]

Consolidating through labor market reforms and program cuts appeals to instinctual common sense and is sure to gain a lot of votes with a concerned electorate. It stands to reason that hunkering down and waiting for the storm to pass will allow an economy to rebound with increased efficiency when the situation improves.  However, implicit in this understanding is that the economy will in fact start on its own, that the depressed economy is like a storm, an outside force that will improve regardless of a leader’s response.  If, instead, the depressed economy is made more depressed by the consolidation, then leaders may be hunkering down waiting for a storm that will only grow stronger.

Who is to say how long the storm we are currently experiencing will last?  The precedent is not pretty.  In many ways, the initial financial shock of the Great Recession resembles the Great Depression in type and scope.  In fact, three of the five biggest economies in the European Union (Great Britain, Italy, and Spain) are doing worse through for years of the present crisis than they did in the Great Depression. [2]  The Great Depression lasted over a decade and only was resolved by the unnatural stimulation of a world war.  To put it another way, after an entire decade, the economic storm had not passed.

Certainly, with the advances in modern macroeconomics, especially in central banking to prevent the deflation that was so prevalent during the Great Depression, a similar slump is not likely to last a decade.  In fact, the modern analogy is worse.  Japan, the world’s second largest economy at the time, suffered a balance-sheet recession very similar to our current crisis after the collapse of their own housing bubble in 1991.  The swift growth of the 80s gave way to a “lost decade” of persistent deflationary pressures and little growth.  Without a war to end the cycle, the slump continued into the 2000s, sparking a quantitative easing policy that only began to spark some growth with the height of the U.S. housing bubble.  That growth was dashed in the global recession, giving way to more deflation to the extent that Japan intervened multiple times last year to prevent its exchange rate from soaring.  In short, some twenty years later, the good times have not returned, and Japan still suffers from its collapsed housing bubble.

In this light, the idea that Europe can simply consolidate and wait for the good times to return seems ridiculous.  When Europe is consolidating in response to the sovereign debt crisis, what theory or narrative suggests that growth will return over the next couple of years?  Subduing protest in Italy and Greece with unelected technocratic governments may be tolerable if the reforms represent a painful one- or two-year transitional period, but if those reforms perpetuate a decade-long slump, it is purely oppressive.

Already experiencing riots and social unrest against the austerity policies of their unelected governors, one can only imagine the escalation if conditions merely worsen over an extended period of time.  John Maynard Keynes argued in The Economic Consequences of the Peace following the onerous Treaty of Paris imposing reparations for World War I on Germany that deliberately beggaring a powerful modern nation sows the seeds for extreme politics and revolt. [3]  The same critique can be made of the austerity policies now being imposed on Italy and Greece.  Imposing catastrophic unemployment and perpetual depression with reforms required from abroad sows the seeds for nationalistic revolt.  Sacrificing in the name of an international agreement such as the European Union will only last so long when extremist parties are able to offer hope for change.

Consolidation and liberal reform may be desirable to make the southern European countries more competitive in the long term, but how do we get to the long term?  When will the long term arrive?  How will Europe return to growth?  These questions have been pushed aside in the panic of keeping the sovereign debt crisis contained.  They are inescapable, critical, and pressing as reforms are forced on southern Europe in return for sovereign debt bailouts.  How long will individual citizens be made to suffer for sins of foreign financiers and proliferate governments?  Two years?  Ten years?  How long until it is no longer the most politically expedient option?

[1] http://blog-imfdirect.imf.org/2011/12/21/2011-in-review-four-hard-truths/

[2] http://krugman.blogs.nytimes.com/2012/01/28/the-worse-than-club/

[3] https://sites.google.com/site/wapshottkeyneshayek/home/nicholas-wapshott-keynes-hayek-book-extract