Angela Merkel, the German chancellor, is under fire. Hardly anyone likes the “German Way” of dealing with the euro crisis. But unless manna falls from heaven for Germans or we can truly believe that an aging and shrinking population will make us more productive, we should heed the calls of U.S. Nobel laureates in economics and partner countries for Germany to merrily increase its spending.

A different conclusion, however, is reached by those who seek to learn from the experience of countries that ended up over-indebted and dependent on foreign assistance or wish to benefit from the findings made by economists Carmen Reinhart and Kenneth Rogoff (“This Time is Different”) in their analysis of nearly one thousand years of government fiscal policy: when the ratio of government debt to domestic product exceeds 90 percent, the effectiveness of fiscal stimulus is dramatically reduced.

Those who have rushed headlong into this dead-end street are left with just one escape route: austerity. This does not mean giving up on the objective of “shaping the future.” It does, however, mean that the ability to take fiscal action has to be re-established. Reinhart and Rogoff also establish that the most effective solution to this task nearly everywhere and in all circumstances is the reduction of government expenditure (which can be achieved, for example, by raising the retirement age).

Many critics of the German orthodoxy propose that in addition to boosting purchasing power and consumption in Germany, the countries on Europe’s periphery should be helped with a Marshall Plan because, otherwise, the austerity measures would not allow fiscal or other economic policy goals (growth, job creation) to be attained. Several observations can be made in this regard: those who have lived beyond their means in the past and invested in non-productive areas (such as the construction business in Ireland and Spain) will have to rein in their activities in these areas for an extended period. This is likely to dampen GDP growth irrevocably for some time. This will hurt, but it is an unavoidable element of the solution to the problems.

Getting back on one’s feet requires progress to be made on productivity and cost discipline by opening up markets (both countries and products). Germany can serve as an example with the wage and economic policy corrections it made in the period following its poorly organized reunification. There is no refuting the objection raised by German accountants and U.S. critics that the “new mercantilism” cannot be deployed as the solution by all countries simultaneously. For every current account surplus there must also be someone on this planet who permits a current account deficit. Of course, it is preferable that current account deficits occur due to high imports of capital goods in those countries whose returns on additional investments are particularly high, because they are in the process of catching up with other economies, for instance. Current account deficits caused by consumption growth in countries facing an imminent dramatic aging process is not what the world needs, because it generates old-age poverty in these countries. If adjustment is what is needed, generously giving money to those who have misbehaved—i.e., the policies we recently agreed upon—and seducing them not to change, not to restructure, reduces pain now and increases suffering later.

Of course, such desirable international adjustments are all the more attainable and lead to stronger growth when greater involvement by the international community in providing technical assistance to improve governance is provided. Countries that are so needy and capable of development will benefit from improved governance, i.e., of governmental activity and of the administrative apparatus. A Marshall Plan fashioned in this way is what the world needs now.

  • K Bledowski

    As the author writes, persistently high current account deficits that finance consumption in economies with shrinking populations are not advisable. This calls for adjustment in both surplus and deficit countries.

    The deficit countries also face structural impediments to growth, and these need to be unlocked through policy rather than money (“Marshall Plan”). If money were to be deployed as a bridge or substitute for policy, only the richer nations of Europe would be in a position to deliver. Alas, German and Finnish taxpayers are not ready for any New Marshall Plan (the author erroneously refers to a Marshall Plan for the world but I’m sure he meant Europe).

    Adjustment through coordinated policy is both short-term (mitigate defaults and banking crisis) and long-term (more flexible markets for labor, capital, goods and services to compensate for the fixed exchange rate). Right now the Europeans find no consensus on what policies to deploy. If no agreement is found among the EU member states soon, the second-best option is a return to a fully flexible float. It is a step back politically but carries the benefit of quicker economic adjustment.

    Politics is the art of the possible. Economics is about choices. European voters would benefit from a clearer delineation of these two paradigms.

  • But Reinhart and Rogoff were wrong–they failed to distinguish between countries with a sovereign currency and those that were linked to another currency (e.g., the dollar) or were in a monetary union. As every economist knows, controlling a sovereign currency provides the option of driving dramatic devaluation (generating domestic inflation) as an adjustment mechanism. This historically has been much easier to accomplish, much swifter, and with far less long-term damage than internal deflation, which is what the austerity program imposes.

    The tragedy of the Euro is that it imposes all the costs of monetary union and–in the long run–few if any of the benefits of true fiscal/federal union deliver. Europe’s real choice is not austerity, but whether it will move to true federation or disintegrate.

  • K Bledowski

    Fred Carstensen is right on the money. Absence of real debates about the costs and benefits of integration – including on the EMU – has blinded the popular opinion about their rational economic choices. At this late hour in the crisis having this debate is a herculean task politically.