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Tuesday, November 22, 2011

How to deal with the Eurozone crisis (my 2 cents)

Here's a post on a matter only partially related to the topics I normally deal with, which I wrote for an other purpose. But it is an issue that is extremely urgent, so, with the caveat that I'm not an economist, here's my proposal for how to deal with the current Eurozone crisis (and also because I'm grading, so I don't have time to write something new right now):

Guangzhou, China. From over here, it is hard to avoid the feeling that European governments are conspiring to bring down the global economy. It’s an unfair allegation, no doubt: the IMF is doing its part, too.

But it doesn’t have to be this way. The chief obstacle now in the way of effective solutions to the European sovereign debt crisis is the failure to recognize that there are significant differences between the short, intermediate, and long-term problems. Because these problems are distinct from each other they require different solutions. Until our leaders realize this – and I mean national politicians as well as the leadership of organizations like the IMF – we will find it hard to break out of the vicious downward spiral that we are now in.

I want to suggest the outlines of an alternative proposal for how to break the cycle. In so doing, I will leave the longer-term issues (the lack of fiscal and political integration in the Eurozone and the destructive impact of unregulated financial markets on the real economy) aside and concentrate on the short and intermediate term problems we face.

The immediate problem is, of course, the acute crisis we are now facing: ballooning sovereign debts in several Eurozone countries, untenably high yields on Greek, Italian, and perhaps soon French bonds, and a lack of robust economic growth. Given the risk of contagion, broad exposure to bad debts, and the risk of a collapse of the Euro, this is a Europe-wide problem.

As for the intermediate crisis, its causes and severity varies. In Greece’s case, the current fiscal problems result from a combination of too high government expenditures, poor revenue collection, and general public sector inefficiencies. These are significant structural problems that require structural solutions in the intermediate to long term.

But, as Nobel laureate Paul Krugman and others have pointed out, in countries like the U.K. and Italy the causes are entirely different. In the U.K., much of the initial deficit was a natural result of the recession. And despite its debt problems, which in part have to do with having had to bail out its banks, Italy is actually expected to run a small surplus on its primary budget (excluding interest payments) this year. So these countries do not necessarily face long-to-intermediate term structural problems of the same kind and magnitude as Greece’s.

The great challenge, then, is how to deal with the intermediate-term problem – that is, the structural deficits in those countries (like Greece) that run them – without making the immediate crisis worse, and vice versa. And this is where the EU is failing spectacularly.

The Greek austerity measures that have been implemented – attempts to deal with the country’s intermediate, structural problems – so far only seem to make the immediate problems worse. In simple language: firing droves of public sector employees means less taxes to collect and greater burdens on the social services. Similar dynamics are at work in the UK, where the drastic cuts implemented by Cameron’s government just seem to have exacerbated the crisis. In both countries, growth has been stunted and deficits have soared.

It doesn’t take an economist to understand that what is needed to resolve the immediate crisis is instead something akin to old-fashioned Keynesian deficit spending in those countries that can afford it, coupled with raising ECB’s inflation target to relieve the real burden of debt those countries struggling to make their payments. At the very least, we must abandon the simultaneous public sector retrenchments that are currently being forced upon countries across the continent by the IMF and the EU. Such concerted belt-tightening in the midst of a severe recession only threatens to turn a recession into a depression.

But there remains the immediate problem of convincing the bond markets that this does not equate to simply putting off difficult intermediate-term deficit-cutting measures to the future. My suggestion is therefore to enact two-tiered solutions: Attempts to stimulate growth in the present need to be coupled with automatically triggered structural deficit-cutting reforms in the intermediate future when growth has returned.

The automated triggering of such time-limited reforms (in the countries with significant structural problems) needs to be ironclad, so as to impress the financial markets now. Like Odysseus, European politicians in countries that face structural problems need to tie themselves to the mast.

One example of how this could be achieved is deficit-cutting measures that are introduced once certain indicators show sustained and substantial growth, but which – once triggered – would require parliamentary unanimity in consecutive parliaments (with elections in-between) to be overturned. The exact nature of such mechanisms would have to vary according to the different national legal and economic contexts but the important thing is that they are convincing.

Such procedures raise concerns about democratic legitimacy. But governments are falling in Europe and “technocrats” installed in their place to do the bidding of the lenders. We already enshrine our most important political rights and legislative procedures in constitutions that are protected by such restrictions. It only makes sense to employ similar tools to protect our economies against the vagaries of the bond markets until the latter can be tamed. In the long run, we might consider enacting constitutionally required surplus targets averaged over business cycles, inspired by the success of the Swedish budget surplus target.

In order to get out of the hole we are now in, we need to stop digging. This entails recognizing that we are facing different short-term and intermediate-term problems and that we need to respond to them accordingly, with a two-tiered solution that doesn’t solve one problem by making the other one worse.

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