The 1930s depression led to the birth of Keynesian economics, because the prevailing economics orthodoxy had no answers to the crisis. Keynes demonstrated that the government could, and should, intervene to correct a shortfall of demand in the economy. The rise of monetarism in the 1970s saw the challenging of the Keynesian reading of the 1930s. Monetarists argued that the 1930s depression was caused by governments failing to prevent the collapse of the money supply (the amount of money in circulation), which led to a collapse of demand rather than a collapse of demand leading to a collapse of money, as per the Keynesian analysis. Despite their differences, both camps agree that there is an indispensable role for macroeconomic policy in combating a slump.
By contrast, the depression that started in 2008, and which Europe is still struggling to emerge from, has led to the explicit rejection of Keynesian economics across Europe, and the implicit rejection of monetarism. How has a crisis borne largely of poorly run and regulated financial institutions, combined with the creation of a currency union modelled on the gold standard been used to turn the clock back on both economic theory and history? And what does it mean for Europe?
Keynesian critics of the direction of macroeconomic policy-making in Europe have long become accustomed to having their views caricatured. Their criticism of the pace of austerity is presented as a call to ‘artificially pump up demand’. This assertion rests on two assumptions: Keynesians ignore the supply side of the economy, and that Europe’s crisis is a result of government failure to push through supply-side reforms. This chorus of criticism has picked up further with signs of economic improvement in the eurozone and UK, despite fiscal austerity for the last three years.
What have Keynesians actually said, as opposed to what has been attributed to them? They argue that fiscal policy is an indispensable tool to stabilise economies suffering from a drop in domestic demand. This is especially so when interest rates had fallen to close to zero (neutering the effectiveness of monetary policy). When businesses and consumers do not want to borrow and invest even when nominal interest rates are close to zero, monetary policy is unable to stimulate demand. Keynesians also argue that fiscal policy is especially important in a currency union (where interest rates are set for the currency union as a whole rather than for the needs of individual economies). Few Keynesians dismiss the importance of supply-side policies; rather they argued that supply-side reforms will not help address a crisis of demand (and that the wrong macroeconomic policies can outweigh the potentially positive impact of supply-side policies). Finally, mainstream Keynesian economists have not said that austerity would prevent economic recovery at some point. Instead, they have said that recovery would take place at a lower level of activity, with an unnecessary accumulation of debt and the risk of deflation.
Keynesian advice was followed (up to a point) in the early stages of the crisis, and by late 2009, the European economy was recovering (see chart). However a dramatic tightening of fiscal policy in 2010 helped push the eurozone and UK economies back into a recession, which in the case of the eurozone only came to an end with an easing of fiscal austerity over the second half of 2013. Since then, European governments and the European Commission have argued that any attempt to boost demand would be at best useless and at worst damaging.
The rejection of monetarism has been less strident, but no less striking. Monetarists are sceptical that governments can affect the amount of demand in the economy through fiscal policy, but are unequivocal that central banks should prevent a collapse in the money supply. Following the launch of the euro, the ECB initially focused on two pillars when setting interest rates – an inflation target of 2 per cent and a ‘reference value’ of 4.5 per cent annual growth in money supply (M3) – but has quietly dropped the second pillar. Annual growth in M3 slid to just 1 per cent in December 2013.
The ECB is not entirely to blame for this, of course – fiscal austerity at a time of weak domestic demand was always going to hit demand hard (and so reduce inflation). But the ECB (though not the Bank of England) was slow to cut interest rates and reluctant to embrace unorthodox policies such as quantitative easing. This is all the more puzzling as the ECB is modelled to a large extent on the German Bundesbank, which was instrumental in making sure that the ECB targeted the money supply as well as inflation.
Where has this rejection of orthodox thinking led Europe? The chart below shows the relative performance of the US, eurozone and UK economies since the beginning of 2008. The US authorities have followed a pretty much standard textbook approach to the crisis, providing some fiscal stimulus to offset the weakness of demand and injecting as much monetary stimulus as possible. The US recovery has been disappointing (by US standards) but still compares highly favourably with what has happened in Europe.
What about growth prospects? Advocates of Europe’s current approach argue that the reforms being pushed have improved Europe’s growth potential. However, even the European Commission and the IMF – the architects of the European approach – expect a very modest recovery, averaging 1.3 per cent a year for the next three years (compared with over 3 per cent in the US). Many other forecasters are even more pessimistic about Europe’s prospects.
The reason for this pessimism is obvious – the damage done to the supply-side of European economies by low rates of investment (both public and private) and high unemployment (the longer someone is out of work, the less likely that person is to find a job). Far from boosting the supply side of the European economy, austerity has made structural changes less, not more likely: fiscal stimulus in the US allowed the private sector to reduce debt levels, hastening the point at which investment recovered. By contrast, the process of reducing private sector debt levels has much further to go in Europe.
Real GDP (Q1 2008 = 100)
Source: European Central Bank
What has happened to public debt? The argument for fiscal austerity was that it was necessary in order to arrest the rise in debt ratios, even if the result was a hit to economic growth. The eurozone’s ratio of debt to GDP has risen by a bit less than the US’s since the beginning of 2008 (see chart), but the US ratio is now falling quite quickly as economic recovery boosts tax revenues. The eurozone’s debt ratio did drop slightly in the third quarter of 2013, but this reflected an exceptional fall in Germany rather than the start of a trend. Moreover, in a fiscally decentralised monetary union, the aggregate debt figure is pretty meaningless. What matters in the eurozone are the debt ratios of countries such as Italy and Spain. The UK has experienced a huge rise in debt partly because it suffered a very deep recession and slow recovery and partly because of the costs of clearing up its banking sector (around 10 percentage points of GDP).
Public debt (per cent, GDP)
Source: European Central Bank
The reason why the ratio of eurozone debt to GDP is likely to keep rising is a combination of weak growth prospects and weak inflation across much of the eurozone. The ECB would never wait until inflation hit 4 per cent before it raised interest rates, yet it has allowed inflation to fall below 1 per cent, arguing that it needs time to gauge the scale of deflationary pressure. This is a risky strategy. Inflation does not need to turn negative to do a lot of damage. The lower the inflation rate, the bigger the primary budget surplus a government needs to run in order to prevent the stock of public debt to GDP rising , hastening the point at which debt becomes unsustainable. Low inflation also pushes up real interest rates, further depressing demand.
How low is inflation across the eurozone going to go? Much will depend on the international environment. A prolonged emerging market crisis would push up the value of the euro, compounding deflationary pressures in the eurozone. The other crucial variable is Germany. If German domestic demand were to pick up strongly (lifting the country’s inflation rate), this could help offset deflationary pressure elsewhere in the currency union. Higher German inflation would help struggling members of the eurozone to regain export competitiveness relative to Germany, as well as reduce the value of the euro, boosting their exports to countries outside the currency union.
‘Core’ consumer price inflation (annual, per cent)
Source: European Central Bank
Greece aside, the European crisis was not a product of fiscal largesse. Mismanagement of public finances in the run-up to the crisis meant that some countries had less scope to impart fiscal stimulus than they should have done (the UK and Italy, for example). But the crisis was caused by the private sector (the failure of the financial system to allocate resources efficiently and to price risk appropriately) and policy-makers’ failure to acknowledge the implications of launching a single currency. So what explains Europe’s rejection of economic orthodoxy, be it Keynesian or monetarist?
Ideological leanings have played a part in some countries – they explain the restrictiveness of fiscal policy in the UK and Germany, for example. The British government has used the fiscal crisis to push through radical reforms of social welfare in an effort to shrink the size of the state. For its part, the German government has dismissed as ‘Keynesian folly’ calls for it to impart a fiscal stimulus to boost Germany’s lacklustre domestic demand, despite running a budget surplus in 2013.
However, the lack of integration within the eurozone is easily the most important reason for the dramatic decline in the quality of macroeconomic policy in Europe. Eurozone governments’ inability to agree a form of fiscal burden-sharing led to highly pro-cyclical fiscal policy in some countries and has prevented rapid action to address the region’s banking sector problems. The banking systems of some economies are both fragile and too large for their governments to comfortably backstop. This pushes up the cost of capital for banks in these countries, leading to big differences in borrowing costs across the currency union and cementing differences in economic performance. Finally, the ECB has been reluctant to ease monetary policy further for fear of the political reaction in Germany (where officials and policy-makers are worried about the economy overheating and low interest rates are angering savers). Savers cannot reasonably expect a return on their savings when there is a glut of capital across the eurozone as a whole, and businesses are loath to invest, but they are an important electoral constituency, especially in fast-ageing Germany.
In conclusion, it is hard to be optimistic about Europe’s economy while conventional economic thinking and history are being ignored. ECB representatives from the countries facing the most acute deflation threat are becoming more assertive, but the central bank will remain politically constrained. Moreover, the fiscal stance across the eurozone will remain restrictive, not least because of the impact of weak inflation on deficits and debt levels and hence on the scope for governments to ease up on the pace of austerity. Modest steps by the ECB, a gradual clean-up of the banks and a very modest cyclical economic recovery are unlikely to be enough to head off the threat of deflation.
Simon Tilford is deputy director of the Centre for European Reform.