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Europe's austerity pours kerosene on fire

By Joseph E. Stiglitz: 0 Comment(s)Print E-mail Shanghai Daily, May 14, 2012

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[By Zhou Tao/Shanghai Daily]

This year's annual meeting of the International Monetary Fund made clear that Europe and the international community remain rudderless when it comes to economic policy.

Financial leaders, from finance ministers to leaders of private financial institutions, reiterated the current mantra: the crisis countries have to get their houses in order, reduce their deficits, bring down their national debts, undertake structural reforms, and promote growth.

Confidence, it was repeatedly said, needs to be restored.

It is a little precious to hear such pontifications from those who, at the helm of central banks, finance ministries, and private banks, steered the global financial system to the brink of ruin - and created the ongoing mess.

Worse, seldom is it explained how to square the circle. How can confidence be restored as the crisis economies plunge into recession? How can growth be revived when austerity will almost surely mean a further decrease in aggregate demand, sending output and employment even lower?

Flawed markets

This we should know by now: markets on their own are not stable. Not only do they repeatedly generate destabilizing asset bubbles, but, when demand weakens, forces that exacerbate the downturn come into play. Unemployment, and fear that it will spread, drives down wages, incomes, and consumption - and thus total demand.

Decreased rates of household formation - young Americans, for example, are increasingly moving back in with their parents - depress housing prices, leading to still more foreclosures. States with balanced-budget frameworks are forced to cut spending as tax revenues fall - an automatic destabilizer that Europe seems mindlessly bent on adopting.

There are alternative strategies. Some countries, like Germany, have room for fiscal maneuver. Using it for investment would enhance long-term growth, with positive spill-overs to the rest of Europe.

A long-recognized principle is that balanced expansion of taxes and spending stimulates the economy; if the program is well designed (taxes at the top, combined with spending on education), the increase in GDP and employment can be significant.

Europe as a whole is not in bad fiscal shape; its debt-to-GDP ratio compares favorably with that of the United States. If each US state were totally responsible for its own budget, including paying and unemployment benefits, America, too, would be in fiscal crisis. The lesson is obvious: the whole is more than the sum of its parts.

If Europe - particularly the European Central Bank - were to borrow, and re-lend the proceeds, the costs of servicing Europe's debt would fall, creating room for the kinds of expenditure that would promote growth and employment.

There are already institutions within Europe, such as the European Investment Bank, that could help finance needed investments in the cash-starved economies.

The EIB should expand its lending. There need to be increased funds available to support small and medium-size enterprises - the main source of job creation in all economies - which is especially important, given that credit contraction by banks hits these enterprises especially hard.

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