Rob Parenteau: Blinded by Faith – Sinking the Eurozone

By Rob Parenteau, CFA, sole proprietor of MacroStrategy Edge and a research associate of The Levy Economics Institute

Wolfgang Munchau has raised a very important point in his current Financial Times article, “Why Europe’s officials lose sight of the big picture.” The eurozone, Wolfgang points out, is more like a large closed economy than a collection of small open economies, and this has implications for fiscal policy outcomes, yet these implications remain largely unrecognized by policy makers within the region. Wolfgang noted:

The many failures of the eurozone’s crisis response policy have a common cause: the eurozone is a large closed economy. Each of its 17 members is small and open. The political leaders who run the eurozone have a small open economy mindset – every one of them, without exception. The economists they employ mostly use small, open economy models.

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.

In one sense, Wolfgang is merely suggesting that policy makers did not take into account the spillover effects within the eurozone of each country pursuing fiscal consolidation programs at the same time. There is something of an element of the fallacy of composition at play here. If only one country pursued budget cuts and tax hikes in order to reduce its fiscal deficit, the influence on the remaining eurozone nations would be relatively minor, and the attempted cuts might be successful in reducing the fiscal deficit of the country in question. However, if the majority of nations in the eurozone pursue fiscal consolidation programs – programs that are not only ambitious in size and scheduled to be pursued over several years in a row – then the spillover effects should not be ignored.

However, while this pursuit of simultaneous, multi-year fiscal consolidation can only thwart itself by dragging down growth and dampening tax revenues, thereby leading perversely to still higher public debt outstanding, the problem does not lie so much in failure of policy makers to recognize and take into account the interactive effects of fiscal consolidation across countries. Rather, the truth of the matter is that most of the eurozone policy makers and their erstwhile economic advisors are practicing a faith based economics. They believe in the moral purity of balanced fiscal budgets. They also believe private sector activity will pick up to more than compensate for public sector cutbacks. That is the essence of the Ricardian Equivalence Theory, which is a central theoretical proposition that mainstream economists believe in and teach every graduate student to parrot.

Simply put, under Ricardian Equivalence, fiscal deficits are supposedly neutralized by the attempts of the private sector to save more money out of income flows in order to service future tax burdens they anticipate will be required to service the higher public debt implied by the fiscal deficit. To be symmetrical, Ricardian Equivalence must also hold that fiscal surpluses are likely to be neutralized by the private sector deficit spending (that is, spending more money on produced goods and services than it earns from current production). We are left, in other words, with the defeatist conclusion that fiscal policy is fairly impotent with respect to influencing economic growth. It is back to changes in the outstanding stocks of productive capital, available labor and materials and other supply side determinants of growth, with Say’s Law tacked on top of that to insure that miraculously, supply creates its own demand.

However, this symmetry was either broken or ignored by eurozone policy makers who took up the call for what they termed “expansionary fiscal consolidations”, like we saw in Sweden in the early ‘90s and Canada I the mid ‘90s. It is indeed possible to find expansionary fiscal consolidations in history, but the fact of the matter is that they appear to be possible only under very special conditions. They turn up most frequently in small open economies that have undergone a large currency depreciation while their trading partners are experiencing robust foreign growth. They also turn up when sufficient interest rate relief accompanies fiscal consolidation (either due to central bank easing, or bond investors improved outlook and confidence with the commitment to fiscal discipline, or both) and private domestic demand is highly sensitive to changes in interest rates.

Unfortunately, these conditions do not obtain in the eurozone at this time (nor are they apparent in the UK or the US), and policy makers still refuse to acknowledge that an expansionary fiscal consolidation requires special conditions. Many of us pointed this problem out in various forums over the past two years when politicians were pushing the expansionary fiscal consolidation line. (For example, please see my prior posts on Naked Capitalism and elsewhere, especially the “Leading the PIIGS to Slaughterpieces, as well as my presentations at the Levy Economics Institute annual Minsky conferences in 2010 and 2011, particularly the audio and PowerPoint files from session 4 on Thursday during the 2010 conference, which can be found here). Apparently, they were just deaf to it all.

In addition, the policy makers in the core believe in the sustainability of export led growth strategies. Keynes warned about this in the last piece he published before his death. If the reserves earned by current account surplus nations like Germany, Austria, etc. are not reinvested in productive capital equipment and structures in the current account deficit nations, then the deficit nations will not be able to earn the income required to service their external debt in the future. They will default. Or, as economist Jan Kregel put it in very clear terms, if Germany wishes to sell exports to the periphery year after year, Germany can chose to accept either liabilities issued by the periphery, or tradable goods provided by the periphery, but they do not have the option of chosing neither.

It is not in the best interest of the creditor/current account surplus nations to continually accumulate liabilities issued by debtor/current account deficit nations if this simply leads to eventual default on those obligations, but the economists and policy makers in the eurozone are too myopic and too blinded by faith to see this. The European Investment Bank could be used to recycle current account surpluses into productive capital investment in the periphery in a sustainable fashion, but instead, policy makers remain wedded to the faith based economic belief that export led growth strategies are both sustainable and optimal. This neo-mercantilist faith would, by extension, have every nation in the world running a perpetual current account surplus, which is clearly a mathematical impossibility – at least until we find life on Mars that is prepared to barter and truck with us.

Wolfgang cuts far too much slack for eurozone policy makers and economists by arguing their main problem is that they do not realize they are dealing with a large closed economy, and so they are ignoring the spillover effects of the mutual pursuit of fiscal consolidation. But let’s take Wolfgang’s logic on its own. If piece-wise austerity cannot work for everyone because of the fallacy of composition, and hence it will only lead to a failure to meet fiscal targets and higher public debt (as we are witnessing in Greece, Ireland, Spain, and elsewhere), then perhaps it is time to recognize that coordinated fiscal stimulus could work for everyone, possibly even without increasing anyone’s public debt or fiscal deficit!

All the more important to pursue such a path, where positive spillover effects from coordinated fiscal stimulus may obtain, when there are large swaths of productive resources unutilized in the eurozone, and when the private sector is still trying to repair its balance sheet from the aftermath of the prior asset bubble. If the private sector is intent on net saving (saving more out of income flows than it spends on tangible investment) then some other sector must deficit spend. Otherwise, nominal income growth will slow, or implode, as is evident in the nominal income deflation apparent in Greece. Of course, that is all entirely too heretical to even consider, even though it follows from the logic of Wolfgang’s argument, and even though it follows from the principles of double entry book keeping (that are, by the way, centuries old, but somehow remain ignored by macroeconomists who have yet to figure out how to pursue a stock/flow consist approach). Stating such simple truths will only get you burned at the stake by the Neoliberal Inquisition ruling the eurozone (at the moment).

Rather, the real problem is that the policymakers and economic advisors in the eurozone (as well as the UK and the US) are practicing a faith based economics, and the basis of their faith is clearly and patently false. Their ignorance is well on the way to encouraging the emergence of one failed state after another in the eurozone – precisely the opposite of the initial intent behind the eurozone. Greece is already nearly ungovernable.

It is not just that they ignore the fallacy of composition, Wolfgang. They believe in outright lies (and do ask yourself, which interests are served by those lies). They belong to the cult of neoliberalism, and it is killing the rest of us. To their three decade old claim of TINA (there is no alternative to the neoliberal agenda) it is time to see them, and raise them one with the cries in the streets of AWIP (another world is possible). It is high time to toss aside the faith based economics of the neoliberal era and build a world worth living in.

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  1. Diego Méndez

    I agree with both Parenteau and Münchau.

    However, I think they are fixated on the problems of the eurozone, while they may be just the first symptom of a global disease.

    Globalization as we know it is unsustainable. It relies on false premises, just like the euro. The global financial and trade system is imploding.

    1. KnotRP

      Hey hey hey….

      It’s a well known fact that two people who cannot swim, when thrown in the deep end, will drown HOWEVER if they each seek to climb on top of the other’s head, they will both survive by virtue of spending 1/2 of their time able to breath above water (because that’s what my linear ruler says when I draw the line out to infinity…or 12 inches anyway).

      Europe just needs to make sure no one non-swimmer stays under the other non-swimmers for too long….that’s all. It’s
      just a matter of managing fairness….

  2. Jim Haygood

    To their three decade old claim of TINA (there is no alternative to the neoliberal agenda) it is time to see them, and raise them one with the cries in the streets of AWIP (another world is possible).

    Haven’t seen any throngs chanting ‘AWIP’ around here (maybe you misheard them: I weep!)

    My rallying cry is GUNZ! — Give Us No Zirp!

    How about some real yield for a change, Benny?

  3. Ignim Brites

    “even though it follows from the principles of double entry book keeping”

    What does 2 + 2 equal?

    Accountant: What do you want it to equal.

    Any rate, the austerians day is coming to an end. In seven months either Hollande or Marine will be President of the Fifth Republic, neither of whom will support a Teutonic austerity program.

    Then we will see. It should be exciting. Possibly pryroclastic.

    1. Thodoris

      The way I’ve heard it:

      Mathematician: In an euclidean space with addition, zero and one, it equals 4.
      Accountant: Well, after taxes, and taking into account assets’ depreciation, it equals 4 with a 5% margin of error.
      Economist: What do you want it to be?

  4. okie farmer

    I read Münchau’s piece this morning and Eruointelligence’s comment on it, and now this piece, but no one points to the possibility that the neo-liberal agenda may intend to liquidate Europe on the cheap into the hands of the financial elites. Austerity is a means to that end. Reading about the Greek govt possibly liquidating everything the govt owns to pay their bond holders, reminded me of the depression in US when farmers by the hundreds of thousands were bankrupted and their farms seized by the banks. And Bloomberg tells us this morning that Germany is not going to go along with Friday’s meeting consensus anyway:
    While tensions “may die down if markets are suitably impressed” with the summit outcome, Merkel is seeking to keep pressure on euro-area countries to lock in budget discipline, Holger Schmieding, chief economist at Joh. Berenberg Gossler & Co. in London, said in a phone interview.

    “For her, the longer-term reform is at least equally important” because it increases the chances “that the German taxpayer will get back all the money” put on the line in bailouts for Greece, Ireland and Portugal, he said.

  5. /L

    expansionary fiscal consolidations”, like we saw in Sweden in the early ‘90s and Canada I the mid ‘90s. It is indeed possible to find expansionary fiscal consolidations in history, but the fact of the matter is that they appear to be possible only under very special conditions. They turn up most frequently in small open economies that have undergone a large currency depreciation while their trading partners are experiencing robust foreign growth.

    Sweden net export and unemployment 1980 – 2009

    The crisis was never solved, that was a myth. What recovered was GDP growth due to booming net export contribution to GDP.

    Employment has never recovered since then, the domestic market hasn’t really. A gigantic victory for Sweden’s export capitalists that after 15 years of tense struggle to dominate every aspect of Sweden economic life finally got a total victory. They did get EU membership an total control over the central bank total domination over financial policies. A tremendous victory and now they waste the spoils of victory in the Baltic. Between 1994 and 2009 their Swedish workforce have produced approximately the the same as the entire 2009 years GDP in export surplus, an entire year of GDP gods and services that the Swedes have abstained from consuming to send abroad for consumption. The profit from this is accumulating in the pockets of less than 10 %. While the 90 % is mortgage their homes to produce an public surplus.

    Yes the banking and balance sheet recession was solved, the Swedish peoples wasn’t. What really collapsed during the crisis was the domestic market not so much export that was as usual humming on and follows international business cycle. The score of unemployable that definitely is kicked out of the normal labor market is still grooving by the day. Now the Swede is quite timid and submissive and is dumbfounded in the believe that very high taxes is necessary so it can keep this going without serious social unrest.

    The Swede do really believe the very high taxes is necessary despite record high accumulated public surplus. No one is telling them that the financial austerity to accumulate public surplus really is to keep unemployment up in the name of the NAIRU God that is highly worshiped here.

  6. Rodger Malcolm Mitchell

    The author says, “The many failures of the eurozone’s crisis response policy have a common cause: the eurozone is a large closed economy.”

    Actually, the crisis exists because each of the euro nations voluntarily surrendered the single most valuable asset any nations can have: Their Monetary Sovereignty Thus, no euro nation can control its money supply.

    I predicted this crisis in a 2005 speech at the University of Missouri KC in which I said, “Because of the Euro, no euro nation can control its own money supply. The Euro is the worst economic idea since the recession-era, Smoot-Hawley Tariff. The economies of European nations are doomed by the euro.”

    Those who do not understand Monetary Sovereignty do not understand economics.

    Rodger Malcolm Mitchell

  7. avgJohn

    I still think these European finance ministers and other insiders are just managing the “headline news” to manage their shorts and to target and time their equity purchases. Laughing all the way to the bank, or their backyard where the hide their gold.

  8. Mattski

    If I’m Greece, Spain, or Portugal I go back to a small, closed model, thanks, nationalize the banks and create big jobs programs for starters. The Catholic countries are less indoctrinated with every-dude-for-himself Protestant capitalist hoohoo and still stand a tinker’s chance of evolving toward something oriented to use value and basic needs. Countries are not businesses and petty economies aren’t petty–they’re the eco-logical level that people, communities, and territories need to begin with.

  9. Hugh

    The problem is not that the eurocrats can’t see the big picture. It is that they have a different big picture. The one they have maximizes looting. Parenteau is closer to the truth when he says the efforts European elites are pursuing are faith-based. But he and Munchau both get it wrong in assuming that European elites are operating in good faith. They aren’t.

    There seems to be an inexhaustible and never-ending stream of convoluted explanations for why elites consistently choose policies that don’t solve anything but do just happen to enrich them and protect their wealth. At some point, we really need to start applying Occam’s razor. Assume these elites are acting in bad faith and only to protect and further their interests, and all the inconsistencies and seemingly boneheaded shortsightedness and stupidity of their actions disappear.

    Parenteau and Munchau are like two Ptolemaic astronomers certain that if just the right number and kind of epicycles are used their earth-centered cosmology can still be salvaged. Apparently it’s not just the eurocrats who have a problem seeing the “big picture”.

    1. Hugh

      To be fair, my principal disagreement is, like Parenteau, with Munchau. I take a stronger position than Parenteau in that I see the eurocrats less as members of a cult and more actors in a criminal enterprise.

    2. rotter

      “The problem is not that the eurocrats can’t see the big picture. It is that they have a different big picture. The one they have maximizes looting.”

      Which is why neoliberalism is dooming the world to catastrophe. It cant last forever, after enough people are destitute and suffering they will blow it up, and then we’ve degenerated two centuries back to the age of revolution and war. How did such a tiny sociopathic minority gain total control of the policy making apparatus of supposedly “enlightened western democracies” ? They bought thier way into power. I think thats probably the inevitable outcome of capitalist societies. eventually, the rich overclass will buy everyone else. Of course, billions of human beings who werent asked if they wanted to become chattel, wont stay bought.

  10. Paul Tioxon

    The geography of it all poses questions, such as why does one nation suffer worse than others during this crisis while others seem to suffer not at all. In this quick lecture animation, the competing explanations and solutions offered are quickly summed up. One point about the current state of Lebanon is how well they are doing there economically. Having been bombed back into the stone age by Israel in 2006, the entire country, infrastructure and all, roads, bridges, international airport have to be reproduced from the rubble they were left in. Of course to achieve this kind of massive stimulus in America, we would lease the US Air Force to some filthy rich country to bomb us to rubble and then rebuild. But then, that is what de-industrialization is for, see Detroit.

  11. Jim Haygood

    From Bloomberg:

    The Portuguese government forecast the economy will contract more than previously estimated next year as it implements more spending cuts to meet budget deficit targets.

    Gross domestic product will shrink 2.8 percent next year after a contraction of 1.9 percent this year, the Finance Ministry said in a statement about the 2012 budget proposal handed to reporters in Lisbon today. The government had previously forecast the economy would contract 2.2 percent to 2.3 percent in 2012.

    DOH! Who would have imagined that austerity could lead to a chronically shrinking GDP? The IMF never told me this!

    In the U.S., two consecutive years of declining GDP would be called Great Depression II.

    1. Tortoise

      Everyone should know that a reduction in the budget reduces the nominal GDP, ceteris paribus. In fact, there is a multiplier that a place like Portugal may be as high as 1.5; in other words, a reduction of the budget by 1% GDP means a reduction of the GDP by about 1.5%.
      There is a way to see the issue in a different and more realistic way: Portugal, by running a high deficit while being in a low inflation zone, has had an artificially inflated and unsustainable GDP that must now correct.

  12. mashedpo

    You’re on a first name basis with Mr. Münchau? Please – even if you were, the repeated use of the first name is puerile at best, otherwise it discredits the piece (or makes it simply unreadable)

    1. Jim

      Don’t really who Munchau is, but anyone having read the Leading PIIGS to the Slaughter arguments by Parenteau last year would have been ahead of the curve.

  13. Eric

    I do not understand the reasoning behind this story. EU countries can export to the rest of the world, so the EU is not a closed system. In fact, since growth is only in developing countries, the solution for EU countries is to export more to those countries instead of each other.

  14. Ishmael

    Last week there was a discussion on Europe and Yves said that if Europe was in such worse shape then the US then why did the Infrastructure look so good and the people dress so well. My response was debt baby debt.

    Here was an article today demonstrating what I was saying:

    Europe’s lost decade as $7 trillion loan crunch looms
    Europe’s banks face a $7 trillion lending contraction to bring their balance sheets in line with the US and Japan, threatening to trap the region in a credit crunch and chronic depression for a decade.

    By Ambrose Evans-Pritchard
    8:30PM BST 16 Oct 2011

    The risk is “Japanisation” without the benefits of Japan: without a single government, or a trade super-surplus, or 1pc debt costs, or unique social cohesion.

    Even today, the jobless rate for youth is near 10pc in Japan. It is already 46pc in Spain, 43pc in Greece, 32pc in Ireland, and 27pc in Italy. We will discover over time what yet more debt deleveraging will do to these societies.

  15. Fiver

    But the core assumption of fiscal stimulus is that there is nothing fundamentally wrong with this economy, that it merely needs the deployment of hydraulic stabilizers, and that, having bought a couple years’ “growth” we’re all back in the fast lane again – as if 1980-2007 was a “fast lane” to anywhere other than calamity.

    I can see nothing whatever to substantiate that view. Absent radical changes across the gamut of policy and law, at best you provide the base for ignition of yet another trickle-down bubble, one from which this badly damaged democratic system won’t recover at all.

    Which is why the entire planet is receiving blanket coverage of drones:

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