Why we need a temporary non-structural stimulus program to alleviate the severity of the ‘Eurocrisis’

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Europe’s economic crisis lingers for the fifth year. Scores of young unemployed in southern Europe await hopelessly an economic recovery while their governments reduce spending, thereby further deepening the crisis. Although austerity measures have reduced bond yields and show first signs of success, the prolonged recession kicked an entire generation of young people out of employment and risks creating a ‘lost generation’. The popularity of xenophobic and populist fringe parties shows that the damage caused to the European integration process could be permanent. It is essential that we be aware of the hazards of inaction and bring forward a powerful response to the economic crisis.

Austerity measures to solve a sovereign crisis gained its legitimacy through the academic works of Rogoff and Reinhart and point out that economies with a high debt burden grow at a slower rate than those who reduce their debts. Furthermore, nobel prize laureate Milton Friedman (in his famous ‘Essays in Positive Economics’) and the Chicago School supports the idea that fiscal spending creates market distortions and produces suboptimal results. All these scholars advocate for a strong monetary response which we have seen from the Federal Reserve (see, for instance, Ben Bernanke’s London speech on ‘The Crisis and the Policy Response’) and to some extent the ECB. Thus, after supplying enough liquidity, they expect a recovery of demand through the efficient market mechanism.

The financial crisis of 2008 and the ‘Eurocrisis’ are so called balance sheet recessions where big debt burdens have set great strain on the financial markets up to a point where we have seen a malfunctioning of the markets. This phenomenon has been described multiple times by Paul Krugman and labelled as the liquidity trap or as a savings glut (see, e.g., here and here). Due to market malfunctioning the liquidity pumped into the market by central banks does not reach firms but is held back at the banks. Empirical studies as well as anecdotal evidence suggest that European firms are turning to the stock market rather than to banks for financing. This occurrence has multiple causes but accentuates the difficulty of accessing bank financing in an environment of distrust and increasingly tight bank regulation (Basel III). Therefore, pumping liquidity into the market does not increase demand, and the economy does not recover. Furthermore, the liquidity increases the fear of inflation among the most conservative economists.

Thus, we are left with a controversial conundrum; either we accept direct lending from the central bank which may spur inflation, support some form of fiscal stimulus plan or watch a generation of young people go to waste, which is hopefully not an option.

Fiscal stimulus seems to be an impossibility in the current state of austerity; any stimulus would only increase the deficit and increase the debt burden. However, fiscal stimulus must not necessarily be financed by the periphery states alone, but can be financed by a Pan-European fund. Furthermore, the stimulus must not be permanent in nature and is, if temporary, less likely to affect the credit profile of the strained economy. Concretely, a Pan-European stimulus program could be co-financed by the northern states and could focus on temporary measures to increase the integration of European telecommunication, energy and transportation markets. This stimulus would also deliver a strong political signal to the young forgotten generation and will not only improve the economic prospects of the periphery but strengthen demand in the internal market, thereby increasing confidence of firms to invest in Europe.

Critics in Germany point out that such programs are forbidden by the European treaties and that austerity forces the governments in the south to be frugal. Furthermore, they argue that the stimulus does not represent the outcome of the pure market mechanism. On the one hand, these critics do not consider that treaties have no educational value but must serve EU citizens. These treaties are human made and did not foresee the magnitude of the ‘Eurocrisis’. The same argument would justify treating a wound without anaesthesia to teach the patient to be more cautious. On the other hand, Weidmann and Co. should realize that the market is being heavily influenced by artificial liquidity and tighter regulation making it impossible to judge whether the current economic situation itself is a result of the efficient market mechanism.

Thus, the economic reality faced by the young people in southern Europe calls for a strong and brave policy response by all stake holders in the Eurozone. Structural austerity measures should not be abandoned but accompanied by a temporary fiscal stimulus program similar to how injuries are often treated with invasive surgeries and painkillers. Absence of action will reduce future economic competitiveness and create a permanent drag on the economy. The young people of Europe demand that policy makers look beyond ideologies and act according to their best knowledge. European leaders need to demonstrate their commitment to Europe, otherwise it will be impossible to convince anyone else to do so.


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