Economic Fairies

The Cameron-Merkel-Sarkozy focus on austerity as the basis for the solution to the European economic crisis – what Ed Ball’s has labeled “Camerkozy” Economics – relies heavily on myth. The myth is that cutting public spending to the bone while pursuing structural economic reforms (especially to labour markets, tax systems and regulation), increasing unemployment and deflating the economy will produce confidence amongst investors and spur growth. This strategy, which ING refers to as “Austeria”, Paul Krugman, winner of the Nobel Prize in economics economists, suggests is like wishing for the confidence fairy to appear.

Greeks chose the Euro and are now waiting to see if their elected officials can form a government, which looks unlikely and their exit from the Euro now looks inevitable. Spain’s borrowing rate hit record highs at 7.3% for a 10 year bond and the rise in the UK’s long term youth unemployment is 800% from 2000. In all some 8.2% of Britain’s working population are unemployed. No sign of the confidence fairy there.

Economic growth across the Eurozone and in Europe as a whole is, to say the least, disappointing and this has led to an undermining of asset prices and led to challenges to bank solvency. Governments are slow to react and collective government is demonstrably not up to dealing with the crisis. Confidence is sapped each time a “major fix” is announced – like the Spanish bank bail-out, since such “solutions” do not inspire confidence in the political leadership and will to deal with the crisis.

At the G20 is Mexico the EU Council President, Jose Manuel Barroso, made clear that the EU was not there to be lectured by others, especially the US whose banks he blames for all of the EU troubles. This may be thought of as fairy speech – finding the evil fairy as far away from home as possible. His outburst in Mexico shows why leadership is a challenge in Europe – he is clearly not accepting that the decision to forge ahead with currency union without fiscal and political integration and the decision to bend the rules and ignore the facts so as to admit Greece to the Eurozone or the decision not to toughen banking regulations are the root causes of Europe’s problem. Nor is he accepting that the paucity of leadership in Europe, evident throughout this crisis, is now making the problems worse.

What is needed are measures to stimulate demand. This requires more public spending, more encouragement for corporations sitting on substantial piles of cash to spend and invest, more encouragement for hiring and a strong and relentless focus on reducing unemployment. Though in the short term this may increase debt, this is the price to pay for the moral requirement to create meaningful employment for all able to work. Once growth returns, then Governments can resize their spending.

So as to stimulate the economies of Europe, some labour market reforms and tax reform may be necessary. The focus of tax reform should not be on reducing taxes for the rich but on ensuring equity in tax policy and easing capital investment, stronger use of flow through shares and changes to capital gains tax.

This is a strategy Paul Krugman has been promoting and it has earned the label Krugmania. An analysis by ING suggests that the adoption of Krugmania will lead to a significant boost to employment and GDP growth of between 2.5 and 3% within twenty four months. While this may also lead to some inflation, this is the cost of supporting a strategy focused on full employment.

Britain has started to recognize that Austeria is not working and has signaled that it will invest £140 billion ($225Can billion) in the economy through a complicated scheme supporting private capital through government guarantees. Whatever the merits of the approach (see a critique by Martin Wolf of the Financial Times here), which is aimed at making sure that the £140 billion doesn’t appear on the Governments balance sheet, stimulus aimed at growth is occurring, albeit on a very modest scale. The Government is focusing on how it should effect stimulus, not whether or not to have stimulus – this is what is important here.

If you want the tooth fairy to appear, then you must put a tooth under the pillow. If you want the confidence fairy to appear, you must stimulate economic growth by putting public money into the economy. Fairies will abound.