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DR. JIM LEONTIADES
Cyprus International Institute of Management
Countries in the Euro-zone which are in economic difficulties have been advised to follow (whether they like it or not) the German economic austerity model. This has been prescribed as a cure for the ills of the over-indebted countries of Greece, Ireland, Italy, Portugal and now, Cyprus. Years of public spending and overconsumption based on borrowed funds have eroded the financial credit worthiness of these countries. Instead of employing the borrowed funds in productive investments they have used these to fuel their “good times”. Following this path, their industries have lost competitiveness.
Austerity is the medicine prescribed by the leaders of the Euro-zone as the road to bring these countries back to economic health. More accurately, this is the position of the ECB, strongly backed by Germany. If you cut back on the public sector, raise taxes, freeze wages, this will lead, so the thinking goes, to a restructuring which will bring the country back to economic health.
Surviving the Short Term
This thinking has considerable merit. The economies of these countries require restructuring. The over borrowing and over consumption has warped the structure of their economies away from that required to remain competitive. To regain competitiveness changes are required in order to repay the borrowed funds and to reduce spending on consumption and relatively less productive investments. But such changes take time, perhaps years. That is the catch.
Although it’s admirable and advisable to plan for the long term, we all have to survive in the short term. The pubic sector worker released from his comfortable desk job today is not going to reinvent himself or herself tomorrow as a programming wizard or a captain of industry. Funds from unproductive investments will not overnight be reinvested into more productive channels.
How to Get There
The debate is not about what is desirable in the long term but rather how to get there. This is where the German austerity model is deficient. Improved competitiveness requires, among other things, a stable economic climate and a feeling of confidence over a significant period of time in order for the proposed changes to take effect. The disruption caused by austerity measures which introduce sudden unemployment, new taxes and a downturn in general economic activity brings with it massive financial and psychological shocks which have to be managed. But the Euro-zone has turned its back on the main tool which can do this.
A central bank acting as a lender of last resort is needed. Lacking this, the finances of these countries are at the mercy of random supply and demand imbalances as well as speculators. The resulting interest rate volatility and their inability to borrow leads to sharply higher interest rates and a cycle which feeds on itself. The outcome is a climate of high interest rates, banks reluctant to lend and consumers reluctant to spend. Countries whose central bank can act as a lender of last resort, providing unlimited liquidity to the market, (as in the USA, UK) have not been subject to the same financial volatility despite having high levels of national debt.
Germany and the ECB remain adamantly opposed to anything that looks like a bank of last resort, including the issue of Euro bonds. Angela Merkel’s 43 year old protégé, Jens Weldmann, who is a member of the ECB board as well the head of the Germany’ powerful central bank, has repeatedly gone on record to reject the idea of the ECB acting as “lender of last resort”, as has Angela Merkel herself. Changing their minds will be difficult. To quote Poland’s foreign minister, “I fear Germany’s power less than I am beginning to fear its inactivity”. He asks Germany to lead Europe out of the crisis.
A Change of Direction
Meanwhile, the financial contagion has spread to include the Euro-zone core countries.
France, Belgium and even Germany are now experiencing financial difficulties. We have now reached the tipping point. Despite the opposition of Germany, either the ECB will change its stance and provide for greater financial support for the crisis countries (perhaps Euro bonds) or it will soon be facing another crisis. This time, the very existence of the Euro-zone as it exists today will be the issue.
Two types of economies will emerge from the current crisis. Those that used the necessary austerity as an opportunity to restructure their economies for greater efficiency and those that went through the austerity phase with little to show for it. The latter will be those countries where the austerity fighting measures brought about no significant change either in reducing a wasteful and inefficient public sector or encouraging more productive investments. Worse still are measures which either through taxation or legislation actually drive away businesses that are necessary to regain competitiveness.
