This is the original English version of my article that appeared in Italian in “La Repubblica” on 16/3/2015
We often hear that the problem in Europe is that there is a monetary union with no fiscal union and that this cannot work, has not worked and is the origin of the current fiscal crisis in the Eurozone. What is usually meant by this is that some countries were allowed to spend too much (i.e. were fiscally irresponsible), which got them into trouble with high debt/GDP ratios, while others were more ‘prudent’ (i.e. fiscally responsible), tightened their belts and become more competitive. The recipe that follows from such an analysis is that what we need today is for the weaker countries (e.g. Italy, Greece etc.) to cut their public budgets (and of course, as usual, workers’ wages) to become strong.
Nothing could be further from the truth. And at the Ambrosetti meeting in Cernobbio on Lake Como last week (what William Safire called an ‘elitist’ version of Davos!) we heard some better arguments from Richard Koo, Yanis Varoufakis, and … myself. As the meeting was Chatham House Rules, I’ll focus on the issues that we have all been discussing for some years now outside the walls of the magnificent Villa D’Este (pictured in the icon above). Let me focus on the short-term and the long-term reasons why the tale above is just a tale, and is continuing to keep the EU in dire straits.
First, the short-term reasons. Richard Koo, the Chief Economist at the Nomura Research Institute in Japan, argues that Europe has confused its structural problems with its balance sheet problems and that while the latter are much more urgent, we have wrongly prioritized the former (though many say not enough). By balance sheet problems he means that when an economic crisis is provoked by excessive private debt, after the crash business naturally focuses on de-leveraging, i.e. saving rather than taking out more debt. And no matter how low interest rates go, business will not invest. Indeed, today we are witnessing very low consumption and investment at 0 interest rates causing deflation, rather than the usual prediction that such low rates would increase inflation. If this saving by the private sector is accompanied by saving by the public sector—i.e. if government acts ‘pro-cyclically’ (tightens its belt)— then we get into serious trouble: recessions can become depressions. He has argued that Europe should have learned from Japan’s mistakes when 15 years ago, after its own crisis, its government acting pro-cyclically, increasing taxes and cutting spending which instead of reducing its deficit increased it by 70% (due to the massive fall in investment and demand).
Europe is unfortunately still not learning the lesson, as national governments continue to focus on cutting spending. And, as I’ve argued elsewhere, the EC investment plan is inadequate, based on the assumption that a €21bn investment (of which €8bn is taken from another EC pot dedicated to innovation) can have a leverage ratio of €15, magically turning €21 billion into an investment of €315 billion. How can this happen precisely in an era in which the private sector is not investing enough—let alone with such a kick? The USA on the other hand, learned from the Japanese lesson and in 2009, after the beginning of the crisis, not only created new money through massive quantitative easing (QE) but also increased government spending by $800bn dollars on an investment plan (called the 2009 American Recovery and Reinvestment Act ), which, in the short run, increased the deficit to 10% (and we argue about 3%!) but in the long run reduced the debt/GDP ratio due to the effect of such a stimulus on growth (the denominator) being witnessed today.
Now I come to the LONG TERM reasons, that I focused on in my session at Cernobbio on financing innovation. The countries that are doing well today in Europe are those that have been investing more (not less) in all the areas that increase productivity: human capital formation; education; research and development; and key public institutions, like public banks which provide patient capital to innovators (KfW in Germany) and organizations that increase the links between science and industry (e.g. Fraunhofer Institutes in Germany) – both increasing productivity across sectors. What has been lacking is a common investment plan in the EU (an investment pact), not a common plan for where to cut (fiscal compact).
And indeed, Yanis Varoufakis—who also presented last week in Cernobbio—has been arguing for such an investment plan, before becoming Greek finance minister. He is often accused of being too academic and not ‘politically savvy.’ Nothing could be further from the truth. What we need today are precisely politicians that know how to make the link between long-term thinking and how to solve short-term crises. Varoufakis has been working since 2010 on a modest proposal for Europe directed at laying a foundation for an investment led recovery. He was not listened to. The proposal aimed to allow the European Investment Bank (EIB) to issue bonds directed towards productive investment, with the ECB ready to purchase those bonds. In essence this would amount to a form of ‘directed’ QE, allowing money creation to actually increase growth in the real economy, rather than to simply end up in the coffers of banks. And since EIB bonds are triple A rated, this would be much less risky for the ECB than buying national bonds. Only if money creation is ‘directed’ towards productive areas, invested in viable projects that can produce long run returns, will we get a more balanced Europe.
In his speech in Cernobbio, which is now live on his website, Varoufakis said his plan should be called the Merkel Plan (!) because Germany will benefit from an investment driven Europe that is less skewed, between member states, in its competitiveness. But until Germany admits that the real crisis in Europe is not due to differences between different member states’ spending but to differences in their innovation and investment activities, then unfortunately this proposal is not likely to be adopted. That is, Europe should have a common investment plan so that more countries do what Germany actually does (e.g. investing in R&D and vocational training, constructing a strategic public investment bank, investing in science-industry Fraunhofer Institutes, envisioning a green transformation of all sectors through their ‘energiewende’ policy, and redistributing wealth between its regions) … not what it says it does (tightening its belt!).
In the end, no matter how many structural reforms we engineer, and how much money we create through QE, Europe will go nowhere until it begins to construct a new future. A future in which both the public and private sectors invest more in those key areas that will foster future growth. There is nothing inevitable in ‘secular stagnation’. It seems to be the road we have chosen.
Let’s change direction!
Tags: Austerity, Eurozone, Financing Innovation, Innovation Policy, Patient Finance, State Investment Banks