16 October 2011

Wolfgang Münchau: Why Europe’s officials lose sight of the big picture

Right at the moment, the failure to adjust to the necessities of a large closed economy is the single largest force behind the crisis. Small open economy thinking has brought us uncoordinated fiscal austerity packages. Jointly, these programmes have had a profoundly negative effect on growth, one that the small open economy crowd was unable or unwilling to see. All forecasts for economic growth and budget deficits have been too optimistic because governments failed to take into account their full impact. Not only Greece and Ireland are missing their targets, but so will Spain and Italy. I expect a full-blown recession in Italy next year, and an overall increase in the deficit. So the net effect of austerity will be an increase in debt.

How could this have happened? When Member States drew up austerity programmes, they assumed that the world around them remains unchanged. The small open economy mindset is not limited to Member States. The European Commission also fully bought into that ideology. As the only institution capable of correcting the small economy drift, it ended up amplifying it. What they ignored was the cumulative impact of those programmes on the eurozone itself, and on the rest of the world. The eurozone has become a large, closed economy. It is not a giant version of Finland. Macro-economic policies matter.

And so do micro-economic policies. If the European Union imposes a 9 per cent core tier one capital adequacy rule on all European banks, as currently under discussion, it will create a severe macro-economic shock when the economy is heading into a downturn, or recession. I am not sure they have done the maths on this one.

A senior eurozone policymaker, who was upset by my criticism of eurozone policy in the past, made the point that some of the most qualified experts in Member States, the Commission, the European Central Bank and the International Monetary Fund, had drawn up these programmes. Did I think they were morons, he asked? I would not use those words. But I can only conclude they are either ill-informed or not telling the truth. I cannot see how somebody with a solid training in macro-economics, and with minimal sense of honesty and decency, could come up with the fairy tale of an expansionary fiscal contraction? Or even with the less extreme but still wrong notion that co-ordinated austerity programmes would not affect growth in the short-run?

We know better. The IMF economists Jaime Guajardo, Daniel Leigh, and Andrea Pescatori [1] recently produced new empirical evidence on expansionary fiscal contractions, based on a large set of data from members of the Organisation for Economic Co-operation and Development. Their results destroy that theory. The data show that, on average, a fiscal consolidation of 1 per cent of GDP has on average reduced real private consumption by 0.75 per cent within two years and a fall in real GDP by 0.62 per cent. There may be reasons why a country would want to impose austerity. But do not fool yourself into thinking that it has no macro-economic impact.

European economists are not the types who give up on a theory on the basis of empirical evidence. They blame the failure of the Greek programme on external factors beyond their control. So I am not surprised that the consequence of a failed austerity programme is another austerity programme.

What about the ECB? In fairness, it has been the only institution in the EU to view the eurozone as a single economy. It would also be unfair to blame the ECB for the legal constraints under which it operates, and which reduce its margins for manoeuvre to a greater extent than commentators tend to acknowledge. But it has committed two policy errors in the past three years, in 2008 and again this year, when it prematurely raised interest rates. It did so because it set itself an ambitious and asymmetric inflation target – to keep inflation below 2 per cent. This has produced a policy bias. One of the first tasks of Mario Draghi as the ECB’s president will be to cut rates aggressively. Another, more subtle task will be for the ECB to pay greater attention to its policies’ impact on the rest of the world.

You can summarise the eurozone’s dilemma thus: while the sum of 17 small open economies is a large closed one, the sum of 17 small open economy policymakers is a group of 17 small open-economy policymakers, who reinforce each other. I fear that Sunday’s summit is not going to bring us closer to resolving the crisis.

[1] Expansionary Austerity: New International Evidence, (IMF) Working Paper 11/158, July 2011

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© Wolfgang Münchau