Monday, April 30, 2012

European Austerity - Wrong Diagnosis & Wrong Medicine

Former Treasury Secretary & Harvard-based charmer Larry Summers explains why austerity schemes give him a headache - read his entire piece at the Financial Times HERE:
Unfortunately, Europe has misdiagnosed its problems and set the wrong strategic course. Outside Greece, which represents only 2 per cent of the eurozone, profligacy is not the root cause of problems. Spain and Ireland stood out for their low ratios of debt to gross domestic product five years ago with ratios well below Germany. Italy had a high debt ratio but a very favourable deficit position. Europe’s problem countries are in trouble because the financial crisis under way since 2008 has damaged their financial systems and led to a collapse in growth. High deficits are much more a symptom than a cause of their problems.
Treating symptoms rather than causes is usually a good way to make a patient worse. So it is in Europe. Its financial problems stem from lack of growth...

This means austerity measures at the national level are likely to be counterproductive in terms of creditworthiness. Fiscal contraction reduces incomes, limiting the capacity to repay debts. It achieves only very limited reductions in deficits once the adverse effects of contraction on tax revenues and benefit payments are taken into account. And it casts a shadow over future growth prospects by reducing capital investment and raising unemployment, which takes a toll on the capacity and willingness of the unemployed to work.

These considerations are magnified in Europe as a whole. Slowdowns in one country reduce demand for the exports of others. Increases in saving and exporting in some countries have to be offset by equal increases in spending and importing in others. Germany’s enormous success in recent years has been achieved by becoming a large-scale net exporter – it would not have been possible without large-scale borrowing and importing by Europe’s periphery. The periphery cannot possibly succeed in reducing its borrowing substantially unless Germany pursues policies that allow its surplus to contract.

Sceptics will rightly wonder how a prescription for more spending by countries that already have trouble borrowing can be correct. The answer lies in the difference between borrowing by an individual and by a country. Normally, an individual helps his creditors by borrowing less, but a person who stops borrowing to finance commuting to work does his creditors no favour. Similarly, since for a country income is determined by spending, a country that pursues austerity to the point where its economy is driven into a downward spiral does its creditors no favour.

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