'New Economic Thinking' and the governance of Europe

The contradiction between the attempt to establish an effective governance and the outdated equilibrium models based on the monetarist economic thinking.

The European council has decided to establish a task force on Fiscal surveillance with the new EU-President Herman van Rompuy as chairman. At the Council meeting in October 2010 the task force is expected to report on guidelines for future economic governance of the EU-member states on a number of economic issues: Firstly, strengthening budgetary discipline through the Stability Pact. Secondly, reducing divergences in competitiveness between the Member States. Thirdly, ensuring an effective financial crisis mechanism. Fourthly, improving economic governance and coordination.
It is certainly a number important issues with relevance for the future economic development of European economies. The mandate of the task force was confirmed be the European Council at its meeting on 17 June 2010:
All Member States are ready, if necessary, to take additional measures to accelerate fiscal consolidation. Priority should be given to growth-friendly budgetary consolidation strategies mainly focused on expenditure restraint. Increasing the growth potential should be seen as paramount to ease fiscal adjustment in the long run.
One crucial question is, what were the economic rationale behind this seemingly self contradicting mandate? And to what extent should the Ministers of Finance accept a strengthening of the Stability Pact. The intention with the mandate is to entitle the EU-Commission in the future to sit at the table in all member countries when the national fiscal budget is negotiated.  A decision that will empower the Commission to dictate the size of the budget deficit and – depending on the recommendations from the task force – the composition of public expenditures.  These intentions are politically rather controversial and will be resisted by some of the more nationalistic member states.  This is so, because the Commission also wants to get the right of fining governments with economic sanctions, if they do not follow the instructions.  Currently, this kind of penalties only applies to those countries that are member of the economic monetary union.
The rhetorical counter-question to the resistance of giving the Commission this authority with regard to the national budgets could be, 'what interest would the EU Commission have in not giving the objectively best advice with the aim of promoting growth and prosperity across the EU?’  and further on 'just see, what has happened in Greece?’.  These counter-questions are encumbered by two serious mistakes.  Firstly, the economic advices from the EU Commission are not objective: because they are based on monetarist economic thinking.  Secondly, we are not only talking about the special Greece case, but of giving advices to all EU countries, of which 24 - including Germany - have, according to monetarist theory, an excessive budget deficit.
In any case the member states should before they delegate any further power to the Commission contemplate, why unemployment has been so high in Europe for decades? and furthermore, why it has never been higher in the year 2010 ever since the 2nd World War?  In the euro zone, registered unemployment is now more than 16 mill.  persons, representing 10 percent of the workforce. The EU Commission cannot be exempt from a significant responsibility for this unhappy development looking at its previous advices in a number of cases. The EU Commission as well as the European Central Bank use monetarist economic thinking, when they advise on what budget targets, national governments should aim towards.  This economic thinking is firmly based in the American economist Milton Friedman's general equilibrium model.  Here, it is assumed that a privately organized market system by itself can secure full employment, if only market forces are allowed to dominate.  Therefore, economic policy, according to this equilibrium model should be geared towards a balanced public sector budget.
Such monetarist economic thinking has now been practiced in Europe for more than 10 years - with the devastating result that unemployment has never been higher.  The market economic system has been given more than enough time to exercise its equilibrating features, if they were present.  Unfortunately, for the unemployed people, there were no such self adjusting mechanism, which the development during these decades has given ample evidence of. The European market economies have been caught in a situation of permanent imbalances - not only in the labour market but also in the housing market and in the financial markets which have spilled over to the balance of payments and later on to the public sector budgets.  Especially, the financial markets have since the early 1990s wavered from crisis to crisis - a development which did not change by the establishment of the monetary union in 1999.
 Within the last two years these imbalances have even increased dramatically. The recent development in the labour market and on government budgets have conclusively demonstrated that the economic equilibrium models have failed.  In stead, they provide an erroneous description of how modern economies evolve both nationally, regionally and globally.  These models could not mirror the amplified imbalances in housing and credit markets that led to the financial sector's collapse not only in the USA, but quite speedily the effect spread to most European countries.  These imbalances led to a general failure of international trade and a fall in real investment and demand for housing. Without sufficient credit, companies can not invest and households cannot buy new houses. In the industrialized countries the fall in production subsequently drew a wave of redundancies, which exposed the public budgets.
 It is precisely within the analysis of such a situation with increased disequilibrium that equilibrium models are derailed.  It is hard to believe, but most equilibrium models do not include the financial sector in any significant way, ‘because money has no real impact’. Furthermore there is a dichotomy between the labour market and the public sector budgets. Only supply factors matters for real economic growth! Hence,  equilibrium model cannot be used for giving advices on the relationship between unemployment and budget deficits, since they are assumed to be independent.
 The U.S. imbalance economist and Nobel laureate Paul Krugman has therefore proclaimed that there is an imminent danger that Europe is facing a third economic downturn. This is so, because the EU countries across the board have followed the EU Commission's advice on unilateral budget cuts. Krugman compares the current situation in Europe with the development in US in the 1930s. At that time (before Roosevelt was elected) the US government took advice from economists relying on equilibrium theory. The outcome was devastating.
 Fortunately, a broad range of mostly American economists with no less than six Nobel Prize winners in front and $ 50 mill  in the back (donated by George Soros) have this spring initiated and established an institute for new economic thinking ( http://ineteconomics. org).  This so-called new economic thinking focuses on two key phenomena that are absent in the existing equilibrium models: uncertainty and interconnection between the real and the financial sectors. Two analytical phenomena which go together like a pair of Siamese twins, which seem to be crucial for the understanding of macroeconomic development.
This new economic thinking has already influenced the U.S. government offices.  For instance, if you want to understand why President Obama stood more than skeptical towards the European budget cuts, the answer is particularly  to find in New Economic Thinking.  Here it is shown how a prerequisite for reducing a budget deficit is a reduction of unemployment.  Within an equilibrium model it cannot be understood why budget cuts destabilize the real economy and by that the financial trust in government bonds.
But, is the size of the budget deficit not a problem by itself?  Only within the optics of an equilibrium model.  By contrast, within an imbalance/open model the answer will be much more nuanced. Because, it is important to understand that together with a deficit in the public sector there will always exist a financial surplus of exactly the same size.  What one hand gives out, must be received by a second hand - money does not disappear!  This means that the deficit must be matched by an equivalent surplus in the private sector.  Looking, for instance, at  the German economy, the imbalance model reveals that the private sector has a savings surplus of not less than 10 percent  of GDP.  The German firms and households are on the one hand saving as never before, but on the other hand they dare not invest in new jobs or homes. Hence, the German unemployment rate is primarily explained by the extraordinarily high private savings, which is not invested in real capital, but instead used for buying partly German and partly Southern European government bonds. It is the imbalance between savings and investment scale in the private sector, which causes the German budget deficit. Therefore, President Obama gave the German chancellor at the G20-meeting in Toronto the advice that only by reducing the imbalance between private savings and investment there could be created a better balance in the German economy.  Had Angela Merkel listened to this advice based on New economic Thinking she, instead of budget cuts would have increased government real investments and financed them with private financial savings in cooperation with German pension funds and other savings banks.
That brings us back to the agenda of the task force for European governance.  No, it would not be wise to give the EU Commission increased admission to influence on the national budgets as long as the Commission bases its advices on the notoriously outdated equilibrium models.  It will only increase the risk that the mistakes of the 1930s were repeated.
Instead, the European governments (and the European task force on economic governance) should concern itself with ideas from 'new economic thinking', which apparently is much more in line with economic realities.





Jesper Jespersen

Jesper Jespersen is professor of economics at Roskilde University.(jesperj@ruc.dk).
Member of the EMU committee appointed by the Council for European policy,2000, He has contributed at several Parliamentary hearings on EMU respectively in Januar 2009 and Februar 2012. Together with Dr. Bruno Amoroso published L’Europa oltre l’Euro, by RX-CastelVecchi, Roma, Settembre 2012, info@castelvecchieditore.com