Austerity – The Key to Europe’s Prosperity or the Nail in Its Coffin?

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.

The views expressed are those of the author(s) alone. They do not necessarily reflect the views of the American Institute for Contemporary German Studies.

Norbert Walter

Norbert Walter was the former Chief Economist of Deutsche Bank.