EUROPE: INVEST AND REFORM – AND DO IT DEMOCRATICALLY

Europe: Invest and Reform – and Do it Democratically

 The European economies do not grow anymore. Nevertheless, the economic establishments are preparing a next round of cuts in the level of the government expenditures. First, a few Mediterranean economies, such as Greece, Spain and Portugal faced a decline in their growth rates, later followed by Italy, France and Belgium. Now even economies such as Germany and The Netherlands are coming to a standstill. All these countries have failed to achieve their economic goals set a few years ago. Government deficit and debt ratio are the indicators that play a decisive role in this respect. The first expresses the relationship between budget deficit and gross domestic product; the second is the ratio between total government debt and gross domestic product. The last one is the most important one, of course. To get a lower debt ratio, politicians must try to reduce budget deficits, while stimulating the growth of the economy. Which strategy must be taken to achieve both goals at the same time? The establishments in Europe, especially leading figures in the financial world, develop their therapies on the basis of a so-called neoclassical or monetarist view on the world. Their answer is: the government is to be blamed for the lack of economic growth, and only lower government expenditures and less regulation of markets will lead us back to stable economic growth. So far this strategy has failed severely. In this text we will discuss the presumptions of the dominant neoclassical analysis and offer one of the alternative approaches, namely the Post Keynesian approach, to see what sort of analysis and therapy it has to offer to get out of the crisis.

The neoclassical approach

The neoclassical analysis of a free market economy is based on the assumptions that actors are economic, rational and non-social. It means that all individuals and organizations such as firms, are motivated to reduce scarcity of natural resources as much as possible and are motivated to do it in the most rational way. The actors are constantly searching for the latest information about prices and quantities and qualities of goods, and use this information in their decisions with respect to all sorts of transactions. The world is a large set of free markets and every actor and every market is small relative to the whole of the economy. It means that mistakes of actors can lead to market disequilibria, which are so small that they cannot disturb the economy as a whole. Those who make mistakes, must accept the losses, restructure or go bankrupt.

There is only one market, which is large relative to the whole, and that is the money market. Disequilibria on this market do lead to disequilibria on all other markets. This might be a sufficient reason for the government to monopolize the control of the process of money creation. In that case the government should delegate this task to the central bank, because monetary management is too difficult for politicians, who might become seduced to abuse this control function.

The task of the government in a free market economy is to guarantee private property rights, and to organise the production of a few public goods, such as dikes. The government must be interpreted as a consumer household; in other words, governments are not productive – they do not invest, whatever they do! It implies that tax receipts should cover all expenditures. Borrowing capital is not allowed as a way of financing expenditures. If governments were issuing bonds to finance current expenditures, their demand for capital would crowd out private investments through an (inefficient) increase of the interest rate. If a particular government continues to create deficits and finances it by means of bonds, it takes the risk that financial markets begin to distrust this government: ‘maybe one day it declares itself bankrupt!’ This would lead to a significant rise in tax tariffs and private investors withdraw their capital from this country as soon as possible. The economy will turn into a severe recession, which can only be solved by the government who starts a programme of expenditure cuts, so as to reduce budget deficit and debts. If just one country is so stupid to elect stupid politicians, the recession might not become that serious, and after trimming the government apparatus trust can return pretty quickly. To help restore this economy a depreciation of its currency might help to adjust to its economic environment as quick as possible. All European economies are small relative to the whole of the global economy. Competition between the different economies will lead to lower deficits and debts.

There are a few serious problems when analysing economic processes in this way. In the first place, the basic presumptions about human nature, namely humans being rational and non-social, are far from realistic. Moreover, the presumption that governments are just consumer households is extremely unrealistic. Major functions such as law and order, infrastructure, education, health care and social benefits have a significant investment character. Another significant problem is the growing interdependencies between economies. Actually the euro-zone has become large relative to the EU-economy and even to the global market economy. In the other words, some units are too big to fail.

A more realistic approach in all the problematic aspects just mentioned is the Post-Keynesian approach. It allows elements of irrationality and sociality into its analysis. Especially the idea of ‘too big to fail’ plays an important role. On the basis of the Keynesian presumptions an ideal-typical macroeconomic analysis has been developed. It shows that a macro-economy, be it a very large national economy, such as the USA, or the European Union economy, or the global economy, is an unstable system. Government intervention is necessary in order to keep the economy on track. Over-optimistic investors can cause a depression and over-pessimistic investors are responsible for the economy to stay in that depression. According to the neoclassical/monetarist Friedman an economy can overcome a depression by an expansive monetary policy. Low interest rates and an affluence of liquidity stimulate private investment and private consumption, bringing the economy back to equilibrium. According to Keynes low interest rates are not enough for over-pessimistic spenders to take risks in an environment that is characterised by declining economies. A lack of demand for goods in a pessimistic environment implies a leftward shift of the demand curve, in the goods as well as in the labour market. Ongoing downward adjustments of prices and wages are the result. Only if the price adjustments are larger than the wage adjustments, labour income will rise, stopping the decline.

Keynes advocates an increase in public investments: infrastructure, such as roads and railways; today he might have stressed digital infrastructure. If the economy is quite liquid – money that is hoarded rather than financially invested – the government can issue bonds to make these hoardings active again. Otherwise the government should create money via the central bank to finance its investments. Only the government is large enough to give the economy a boost large enough to turn the climate of pessimism into one of optimism. This would mean the end of the depression, since private spenders will definitely follow now.

Current debate about Europe

The Germans and the Dutch are the leaders of the group of politicians and economists who advocate policies based on the neoclassical/monetarist view. The main ingredients of their policy are:

  1. Cuts in government expenditures; according to their static equilibrium analysis it will lead to a reduction in deficits and debts;
  2. Budget balance, interpreted as structural expenditures equal to structural receipts; in other words, no deficits or surpluses on average over a business cycle.
  3. Only a common currency if all members accept budget balance and a low level of debts; otherwise, we need a currency system with flexible exchange rates in order to restore disequilibria between national economies;
  4. In many European countries important micro markets function badly; especially labour markets must be made more flexible by reducing government intervention;
  5. In many European countries important collective systems are not designed to adequately tackle future problems, such a the collective pension systems;
  6. Especially in Southern Europe the government apparatus is inefficiently organised; slow in its operation and too many civil servants are appointed without sufficient economic motivation (clientelism);
  7. The current situation is an emergency situation. Even economies such as Germany and The Netherlands are threatened by credit rating agencies for losing their triple- A status. The last few years the ECB has intervened in the bonds market in order to influence the interest rates for the countries under attack. By means of compensating transactions the bank tried to avoid massive money creation. Being a loyal adept of Friedman the bank considers outright money creation so as to stimulate the economies now. Many monetarists are reluctant, however, and talk in terms of the “ nuclear option”.

There are alternative views to be found in economics. Alas, they form a set of marginalised groups – in the media only a small minority. Especially the Anglo-Saxon media are very biased in this respect. Therefore it is very important to become acquainted with more realistic views and policy options. When we apply Post-Keynesian views to the current situation in Europe, we get the following summing up[1]:

    1. The financial crisis of 2008 was caused by a lack of financial regulation. Free market economies are unstable, which means that important markets such as financial markets and labour markets should be regulated so as to function efficiently. Especially the US-economy is badly regulated, and banks and other financial organisations have acted quite irrational. So with the US-labour markets where wages did not rise for more than a decade although labour productivity kept rising with a few percentages per year. This seduced many workers to accept attractive mortgage loan conditions. When the Fed increased the interest rate and the economy began to slow down, the debtors became in trouble, and with them the banks. Since European banks had made comparable mistakes, and had invested massively in American subprime assets, also the European economies became in trouble. A global depression was the result.
  • Fortunately the Chinese were prepared to stimulate their internal spending, which meant – via their increasing imports – a stimulus for the rest of the global economy. Especially Germany has profited from the Chinese contribution. Unfortunately the Europeans refused to participate in a global plan to get back to economic equilibrium. Especially countries like Germany and The Netherlands ignored the fact that the members of the EU and of the euro-zone are too interdependent to implement national policies. The Germans want every member to cut its government expenditures, so as to reduce its deficit and debt. But this policy doesn’t work in a situation where the whole of the euro-zone is in a depression. It only works for a country that is the only one in a depression. Then it becomes cheaper and can improve its export performance. But if all relevant economies are following the same policies, the effects are disastrous. And this is exactly what we see at the moment. Time and again healthy European economies cut government expenditures but the deficits and debt levels are not declining; on the contrary.

 

  1. The euro was introduced about a decade ago. Until now it is a success. And especially in a period of depression it is important to have a European system of fixed exchange rates. Imagine all members of the euro-zone re-introduce their national currencies. They all would immediately depreciate their own currency – which is impossible of course. A price war on the foreign exchange market is the result, creating ever more uncertainty in the economy.
  2. Now we are in the middle of a second depression, which implies that the important spenders are pessimistic about the near future, and the government should step in as the spender in last resort. According to Keynes public investments are to be preferred to public consumption.
  3. If market economies are badly regulated, institutional reforms are necessary. Banks and other important financial institutions, such as large investment funds and pension funds, should be more liquid and more solvent, also in times of seeming ‘stable’ growth. On the labour market the role of discrimination and prejudice should be reduced. In many European economies unemployment among young people and among the group 50+ is much too high in this respect. Many economies, especially the Mediterranean ones, should significantly improve the efficiency of their government apparatus, and make their pension systems ready for the future.
  4. Now Europe faces the second dip, it should stimulate its public investments. It is possible that the European Commission implements a series of proposals that are already made. It is also possible that especially the countries with a trade surplus stimulate their own public investments. Digital infrastructure, railways, education and social care are good examples in this respect. If the investments are not financed monetarily, it leads to higher debts, which might frighten the financial markets. On the other hand, money creation (making something out of nothing) frightens the financial experts too, although this principle is the essence of a growing money economy!Personal viewIn the second place, the irrational financial world has successfully pressed governments to deregulate markets in the course of the 80s and 90s. It will take years to transform the financial sector into a well-functioning part of our society.In the fourth place, European countries were pressed to reform their economies. According to the established view, reform means less regulation and more free markets. To me, we should search for efficient institutions, which is not the same as just markets being as free from government intervention as possible.In the sixth place, the EU should make a simple model of the EU-economy, since most national economy models are flawed, and unable to model the relationship between government expenditures and debts adequately. Also the IMF is constantly making this mistake, and should also make models of larger economic units.

Conclusion

  1. To the new generation of students I like to say: there are simply no authorities in the scientific world. The only authority you must recognize is your self. So, be critical, always and everywhere. And start you march through the institutions and change them, to your benefit and the benefit of so many other people with less talent and opportunity.
  2. Europe is in a severe crisis. But the euro-crisis is not because of the euro, and the debt crisis is not because of debts. The essence of the crisis must be formulated as follows: the establishment in the financial, political and economic-scientific world sticks to outdated and inadequate frames of interpretation of the situation. The media are strongly influenced by the views of the leaders in the different worlds. This irrationality is based on vested interests, making the opinion leaders mentally unable to admit their mistakes from the past and drive them to repeat their short-sightedness.
  3. In the fifth place, Greece did a bad job in the period 2001-2007. So they were not well prepared to counter the Anglo-Saxon depression. The inadequate European reaction made things worse, and transformed the badly structured Greek economy into a ruin. The financial help, meant to help the European banks, was too little and too late, and was offered on counter-effective conditions. The European attitude towards Greece and later to other Mediterranean countries as well, seems to be driven by social rather than economic motivation. North feels superior to South, and wants to punish the South for their bad behaviour. There is some similarity with the situation in 1919, when France wanted to punish the Germans and required extremely high payments from them to restore the economies of the Allied Forces. Keynes warned for this policy, and said: ‘make your enemy to your trading partner’. Applied to Europe today we can say: ‘don’t make your trading partner to your enemy’. The best solution to the problem of North versus South is the following: the South must make their government apparatus more efficient, not necessarily smaller. Further improvements are possible with respect to their labour market institutions. The North appeared to be able to solve the big social conflict between capital and labour and between the different classes within labour. The EU could form a Social-economic Peace Force and send experts in the field of taxes, social security and labour conditions to the Southern countries to help them developing more social en political unity. Both reforms should make Greece to a more democratic country, where the price of adjustments is not only paid by the poor and unemployed, but also by the very rich. The Peace Force should also make the institutions of other Mediterranean countries, such as Portugal, Spain, France and Italy more efficient and fair.
  4. In the third place, the European reaction to the subsequent global depression of 2009 was inadequate. Especially the Germans and the Dutch pressed for cuts in government expenditures. If one country is doing it, it might lead to lower deficits and debts. But all euro-zone countries began to implement this policy – even the Germans and the Dutch! As already said, he effects appeared to be dramatic.
  5. In the first place, the neoclassical/monetarist view, which dominates economic thinking for already half a century, is based on unrealistic assumptions. It can only predict developments well if the economic weather is nice, investments, consumption and production show steady growth, and if those people who are unable to participate in a market economy fully accept their fate. But human irrationality makes a sunny period to a rather short one. As soon as the economy turns into a depression, there are no mechanisms in a free market system that stops the decline. Fortunately in modern societies the government is relatively big, and via so-called automatic stabilizers the depression might be short. Also an expansionary monetary policy might help to shorten the decline. But if there has happened something very bad, such as a severe financial crisis, these mechanisms might be too weak. The Post-Keynesian approach is based on more realistic presumptions. If this approach will be connected with an adequate institutional theory it has the scientific power to be superior to the established view.

[1] For a non-technical introduction into the Keynesian thinking, see: Robert Skidelsky, Keynes, The Return of the Master, Allen Lane, 2009.

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