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The Eurozone needs less voodoo economics: more vision and more strategy

The Eurozone needs less voodoo economics: more vision and more strategy

A shorter version of this blog appeared on the Italian La Repubblica on August 24, 2014.

Why should the deficit be under 3%? Why not 1%, 2%, 4% or even 10%? Is this number perhaps just … taken out of thin air? Italy had a low deficit before the crisis but its debt/gdp ratio continued to grow. That should have made us realize that the deficit in and of itself is not the problem. Yet today all the attention is on that magic—voodoo like—number.


This week Mario Draghi came close to admitting that asking governments to reduce deficits during times of recession is futile, hurting their prospects for growth.  But the reforms he and others continue to call for do not address the core issue. Debt/gdp ratios will only fall when there is a clear strategy for the denominator—and this means investing in concrete areas that will over time increase long run growth and productivity of the entire economy.  Lets start from the beginning.


What matters is not the size of the deficit but what it is composed of. In fact, most of the deficit is composed of nothing strategic at all. Its not about governments wanting to be ‘bigger’ spending more, but rather an automatic reaction to what is happening on the growth side. When growth and employment falter, as in Italy for the last 20 years, the deficit automatically rises due to the cost of things like unemployment insurance, and reduced state revenue from taxes. Thus in reality the deficit is the symptom of the problem. The real problem is low growth and unemployment, which by definition leads to rising debt/gdp. Not the other way around—which remains the current logic driving troika policies, and keeping countries on their knees in a vicious spiral of no growth.


So if the deficit is an automatic consequence of lack of growth, only when focus in the Eurozone changes drastically from the voodoo like number 3% to the types of investments and reforms that will increase employment,  productivity, and growth will we be able to keep deficits in place, and even more importantly allow countries to have some hope of increasing the denominator of debt/gdp rather than only the numerator.


So what do we know about growth? Of course we must have the right ‘framework’ conditions (less red tape, more labor market flexibility, less corruption etc). But without the needed public and private investments that increase long-run productivity, growth is simply… impossible. Unfortunately this continues to be ignored by commentators on both sides of the political spectrum. We are often told, for example, that the German export miracle is due to Schroder’s reforms in the late 90s which held down wages, with the obvious corollary that what Italy and the other ‘peripheral’ countries must also do is hold down wages and increase labour market flexibility.  What is ignored in this ‘analysis’ is that (1) wages in Germany were temporarily restrained as a pact between capital and labour to preserve employment during German unification, which would have otherwise created mass unemployment especially in the western part, and (2) this was done in exchange for not only preservation of employment but also fewer work hours (35) and investments in infrastructure, research, and innovation which create more and better jobs in the future. And it is precisely these investments that have allowed German productivity to outpace that of countries like Italy.


Indeed, the true disaster in the ‘periphery’ is not so much its labour costs, but productivity. The usual proxy used for competitiveness is unit labour costs which can be divided into these two components (a) labour costs and (b) productivity. What is evident in the figures below is that the most drastic difference between countries is not so much the labour costs (in and of themselves, especially when we include social contributions which in Germany are higher) but their relationship to productivity. Italy, for example, has had ZERO growth of productivity for the last 15 years—even negative.


And where does productivity come from? From paying workers less? No. By  allowing them to work more efficiently, with state of the art training, technologically advanced machinery, an innovative division of labour, and harmonious capital-labor relations.  It also comes from having a strategic sense of where one wants the economy to go. When Germany decided to go for the ‘grune strategie’ (green strategy) this required unions, government and firms to sit down at the table, move together transforming patterns of production, distribution, and consumption across the economy and design new forms of education to prepare technicians and engineers for the “green revolution”.


It is time to admit loud and clear that the real problem in Italy is not that workers earn too much, but that wages have not been keeping pace with productivity because the latter has suffered due to stagnant investment by both the public and private sectors alike, and constant infighting both politically and between capital and labor. Private Italian companies continue to be below average spenders on areas like R&D (crucial to productivity) and human capital formation and the Italian public sector is one that continues to prefer to ‘subsidise’ and ‘incentivize’, rather than invest strategically in high growth areas. You can liberalize, privatize and structurally reform everything in the country, but growth will not happen until such dynamic investments and institutional changes take place. This is indeed the ‘strategic’ (not automatic) part of the deficit that is being completely ignored. We must of course reduce waste, reform pension systems so they are more equal cross Europe, and eliminate unnecessary bureaucratic red tape. But unless these reforms are accompanied by massive investments (of the size similar to those in the Marshall Plan, ie 2.5% of EU gdp), with new types of public and private collaboration, that allow productivity to increase and provide jobs and opportunities for new generations, then we will remain stuck in ‘secular stagnation’. And this is not automatic: its of our own choosing due to the complete lack of vision.


It is thus not enough for Mario Draghi to openly doubt the austerity agenda, as Christine Lagarde did 6 months ago, only to change her mind later when UK growth began to make some fits and spurts (due to debt driven consumption- not investment!). What is required is a complete transformation of the way we understand competitiveness and economic growth. Lets hope that Draghi’s new existential doubts begin this transformation.



Productivity and Labour Costs across EU (source: Eurostat)



Tags: Austerity, Eurozone, Industrial Policy, Innovation Policy



Debating the problems in the Eurozone on the UK’s BBC Newsnight, 3 September 2014

© Mariana Mazzucato