Last week we had our annual conference in Brussels. This year’s keynote speaker was MEP and former Belgian Prime Minister Guy Verhofstadt. He gave an impressive and passionate speech about what Europe needs to do to finally get itself out of the economic crisis. Much of what he said made a lot of sense, but on a couple of critical issues I think he is barking up the wrong tree. Unfortunately, what was missing in his analysis is also missing in that of a lot of European economic policymakers, and that’s a worry.
In diagnosing Europe’s problem, Verhofstadt spoke of high levels of public and private debt holding back economic growth. He spoke of the investment gap, which some have estimated to be over €800bn, and pointed to the lack of bank loans to business, possibly signalling a renewed ‘credit crunch’.
His proposed solution was based on the need to finish the job on the single market that was started by the founders of Europe. In the early days of the union, a number of key sectors were protected from policy measures geared towards opening up competition across member state borders, especially in banking and energy markets. These, along with digital industries, were given as examples of where Europe needs to have a radically different approach, of the sort that led to improved productivity and consumer welfare in other sectors during the first few decades of the single market. He called for strong ‘European action’ to turn this around. We have “too much debt and not enough integration”, he said, claiming that there is even a new “Washington consensus” about what needs to happen in Europe. He even cited our keynote speaker from last year, Paul Krugman, who has apparently said something along the lines of ‘Europe did not have enough political integration to make the Euro work’.
Now, I can quite imagine Paul Krugman saying something like that. It’s just stating fact. The Euro was always heading for trouble without stronger institutions, more flexible rules at the ECB and greater political integration than we’ve had. But it would surprise me if Krugman entirely shared Verhofstadt’s diagnosis of the problem, or agreed on the solution. In fact, from what I’ve read, there is indeed an emerging consensus – not so much in Washington but certainly among academic economists – but it’s not quite the one presented by Verhofstadt.
The main challenge to Verhofstadt’s thesis is the question, ‘Where is investment going to come from?’ Aggregate demand in the economy is unlikely to get a big enough boost from an increase in net exports or from consumer spending any time soon. We have near zero interest rates and inflation that is looking perilously close to negative (which of course would make everything worse since it would increase the real value of debt and will also make the private investment situation worse as firms would have to borrow at today’s prices to, maybe, eventually, sell products at lower prices). So if the focus is on investment we have to ask ourselves what to do in terms of policy at a time when both the private sector and government sectors are both trying to rein in debt by reducing expenditure at the same time. This is not a trick question. It is the most important question for the European economy and it has been for some time. The trouble is there is no answer to it. It is this lack of answer that has let Krugman to repeatedly suggest that policymakers focused on austerity in Europe must believe that the ‘Confidence Fairy’ will somehow magically inspire the private sector to reverse its current practice of deleveraging and invest, even though there seems little hope of any demand with which to get any return. This may seem like a joke, but those who have argued for austerity during the crisis really have relied on the notion that cutting deficits would lead to an increase in business confidence that would bring us back to growth. Unfortunately, it hasn’t worked out like that.
So, when Verhofstadt talks of a new credit crunch, I’m asking myself the question ‘Are banks really not wanting to lend to viable businesses? Or are rational businesses reluctant to borrow because of persistent poor demand prospects and the possibility of deflation?’ After all, with interest rates so low there must be some reason, even with a dysfunctional banking sector, that private firms are holding back.
The implications of all this are pretty simple. If investment is unlikely to come from the private sector, then the public sector should step in, at least temporarily. Obviously this should be done with great care and with a focus on capital, infrastructure investments. Indeed, some have argued that with interest rates so low it is almost irresponsible of governments not to invest more at this time. The problem is that EU fiscal rules do not allow sufficient room for manoeuvre given existing levels of deficit and debt. Some policymakers at the Member State level have realised all this and are trying to push the boundaries of what is permissible in terms of expansionary policy within the European rules, but it is starting to cause friction between the real world of Member States and the Brussels bubble. Just look at Italy’s Prime Minister Renzi’s latest budget, which comes close to the line, or the outright spat between France and the Commission over how much to loosen the belt.
The apparent belief, then, in the confidence fairy still pervades the corridors of Brussels despite pretty compelling evidence that the austerity experiment hasn’t worked (see here, here and here for examples and analysis). I regularly still read in documents emerging from DG ECFIN talking of ‘growth-friendly fiscal consolidation’ (a phrase that makes my teeth curl) and, what to my mind is, an irrational focus on public debt as the primary macroeconomic problem that Europe must deal with. Although high levels of public debt are far from desirable, they are surely not as big a problem right now as either the almost negative inflation or the persistently high levels of unemployment, especially in Southern Europe.
So, in conclusion, Verhofstadt’s diagnosis is partly right. Yes, we have an investment gap and, yes, we have high public debt – and these are both undesirable. But public debt is surely not as big a threat right now as deflation and unemployment, both of which, if unchecked, would undermine all attempts to reduce debt anyway. His call for a single market in banking, energy and digital industries seems like a good idea but it will not help us in the short term. If we are to avoid slipping into a Japanese style lost decade we need to find a way of stimulating demand quickly. And I don’t believe in fairies.3