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In The Long Run…

November 20, 2011

Frequently you hear statements in the media about certain European economies, notably the UK, Greece and Italy (it has also occurred in the US, if without the same official labeling) legislating “austerity measures” or the even more juicy “austerity package”. Now far be it from me to accuse the media of misrepresenting the issue, but stories are often reported with the sense that even in the face of significant sociopolitical unrest, the government must do what is right, and push these packages through the houses of parliament.

Unfortunately, this belies much truth surrounding these measures of austerity. In these recent cases, they have been imposed upon these nations by the European Union (and Republican party) as part of an agreement: you accept these measures, we bail out your debt. The problem is that in their coverage of these deals, reporters tend to assume that what the European Union is asking for is sensible and pragmatic, and consequently, even if not ostensibly considered so, the people protesting and rioting in the streets simply misunderstand the situation, or worse, are selfish and simply want more of the Germans’ hard-earned cash. The reason that this is an issue is that when one properly assesses the actions of the European Central Bank, it becomes very clear that their assessment of the current economic climate is far removed from any semblance of the truth.

Much of what the ECB is doing is seeking to stabilise; that is, they see their goal in the economy as to maintain price stability; inflation. So no matter what the consequences are for economic growth, unemployment, or ironically enough; debt, it is the goal of the ECB to maintain control of the money supply. Which is all well and good if you believe the economy naturally equilibrates at maximum efficiency of its own accord, and that government has no role, except the aforementioned price stability, which, being obviously state dependent (ie: different states have different currencies), cannot be issued by the market.

Unfortunately, such a perspective is not tenable, at least not in the current context. As any kind of Keynesian would point out, the economy is malfunctioning and the government is urgently required to restore production. This perspective is evident in both Right and Left Keynesians. While the Tory Keynesian view opines that while the economy normally works fine, there are contexts in which it tends to malfunction, mainly due to the rigidities of both prices and wages, in contrast to the more radical Keynesian view that the economy never operates at full capacity, but rather is suspect to the fragile nature of expectations, particularly when institutional and class factors are taken into account; both firmly agree that the current “Euro crisis” is not a problem of inflation, but production. That is, demand, not supply.

The problem is that, since the radical re-evaluation of conventional economics following the stagflation of the 1970s, reserve banks have successfully convinced themselves that only control of the money supply matters; if inflation falls into line, then so will the rest of the economy. And they may not be completely wrong in that belief (just less-than-completely wrong). The real issue arises however, in a situation, such as a Liquidity Trap, in which people are holding onto cash as a form of savings, instead of say spending it or putting it into a bank account or investment bonds (that is, interest rates are so low that it is impossible to create further growth through increasing the money supply to a level at which people would be happy to use their cash again, ie: at interest rates below zero, which are of course impossible). The issue here is that without inflation, nobody would choose to spend their cash; why would they? Bonds are worthless because their rate of return is so low (as said; interest rates are at low levels), so you might as well hold onto money. And not only are inflation rates actually very low worldwide (although higher than they should be due to constraints on natural resources), but reserve banks, like the ECB, are absolutely determined to ensure that inflation remains at the target 2-3% (give or take, most economies target it at around this rate). In order to have a proper recovery, people need to hold onto less cash, it needs to be worth less, through inflation. But the problem is that this is precisely what reserve banks worldwide are actively committed against!

Now you begin to see the real problem. Many EU countries are in debt. The EU declares that their governments have to reduce spending to rein their budgets back in. These austerity measures are fought with understandable hostility by the nation’s people. The media worldwide unwittingly buys into the notion that these are necessary budget reforms that need to be passed to prevent a crisis. Meanwhile, the only alternative tool through which to restore economic growth, the interest rate (amongst other monetary policy options, such as quantitative easing, which can also increase the money supply), is controlled by the ECB with an iron grip. And thus, we continue in our spiral of debt, deflation and despair, all along the way wondering how it came to this. No matter how many times Merkel and Sarkozy claim that they have the problem solved, as long as they continue to play the same game, the problem will never restore itself.

For you see, the ultimate fallacy of it all is the notion that it will all be okay. The media, not being dullards, note that austerity measures will end up reducing aggregate demand (as a side note: I attempt to use the term aggregate demand as little as I can; Keynes spoke of effective, and not aggregate demand, and the two concepts have subtle but important differences), causing the relevant economies (and others, with the flow-on effects) to re-enter recession. While this notion is considerably misguided even if for the simple fact that most European economies are still experiencing high levels of unemployment, it reflects an underlying misunderstanding about the nature of the economy, one which assumes that a present-day sacrifice of economic hardship will lead to future prosperity, as things “return to normal”.

The economy exists in real time. It is path dependent. It does not exist in any state of normalcy or equilibrium. It simply is. It does not easily return to full employment after recession. There is no tendency for it to operate optimally. We cannot just assume that it will restore itself, because it won’t. It cannot revert back to a point in time that it has left. By removing government spending, the economy will suffer a lack of demand and re-enter recession. But this is not the end of the story. Recessions are not brief, necessary periods of pain. They are periods of deficient production and should be seen as such; markets are not misallocating resources, they just aren’t engaging with them! If austerity measures are undertaken, the economy will produce at a lower rate, one at which effective demand does not guarantee full employment. And it will continue to do so until investors consider it profitable to produce at such a level.

When Keynes declared that “in the long run we are all dead”, he spoke of the uselessness of claiming that despite current trevails, everything would sort itself out in the future. While he initially deplored it as he considered it a sign of intellectual laziness, it came to personify much of Keynes’ eventual critique of the safe, sound, useless orthodoxy. It is sad to see how relevant it remains. Despite all that we have learnt, we repeat the same old lies, that by being moral citizens (and governments), and reducing our consumption and we’ll reduce our debts, so in the future it’ll be alright. If the European Central Bank is successful, Europe’s economy will languish, all under the expectation that the economy will restore itself soon, if we remain patient and austere. Soon. One day feeds into another, as that “soon” runs off into the distance.

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