Death by a thousand cuts

The elephant in the room in the ‘spending cuts' debate is the total lunacy which permeates it. The press hacks all seem to agree that a drastic cutback in public sector spending is not just inevitable, but highly desirable. A few months ago, the German Finance Minister railed against a rise in the level of public sector indebtedness "that will take a whole generation to work off."

More recently, Jean-Claude Trichet warned that EU countries must not accumulate more debts. In London, the head of the prestigious Institute for Fiscal Studies has forecast a £40bn (€47bn) "hole" in public finances. If they come to power in 2010, the British Conservatives are promising 10% across-the-board public spending cuts. Fiscal conservatives are having a field day. Drastic cuts in a deepening recession - how can so many intelligent commentators get it so wrong?

Must the budget balance?

Short of running up a debt two or three times the size of GDP while having a weak currency (the Icelandic case), there is no such thing as an ‘unpayable debt mountain.'

Japan's public debt is equivalent to nearly 200% of GDP, a very high figure, but a sensible price to pay for not falling back into economic depression. At the end of the Second World War, the US government's current deficit was nearly 15% of GDP and its debt-to-GDP ratio as high as Japan's today, but post-war growth soon solved the problem, even while the USA was doling out Marshall aid to rebuild Western Europe.

Britain's debt-to-GDP ratio was well in excess of 100% at the end of the 19th Century, but Edwardian prosperity and colonial tribute allowed it to survive quite comfortably.

Under conditions of growth and fiscal buoyancy, with interest rates close to zero in real terms, debt can be repaid. Nor does ‘printing money' (quantitative easing) automatically lead to runaway inflation, particularly when labour's bargaining power is weak. These ideas emanate from fiscal conservatives, often the very bankers who caused the crisis and seek to ‘shrink the state' at the very time when public spending is needed more than ever.

Spending cuts are not the answer

There are multiple reasons why cutting back on public spending in a major recession will not work. First and foremost is the ‘paradox of thrift' first signalled by Keynes during the Great Depression of the 1930s. Keynes famously argued that what is sensible medicine for the individual cannot be applied to the economy as a whole. The more a country tries to save, the more income and investment fall and the less is available to save. This point is fundamental, but bankers and businessmen (for whom balance sheets must balance by definition) rarely learn any macroeconomics.

Secondly, the combination of financial meltdown and economic recession is deadly. Why? Because not only are banks not lending in order to restore their balance sheets, but their customers - businesses and households - are rebuilding savings as well.

As Nomura's chief economist Richard Koo warns in his recent book, during a recession individual firms switch their attention from profit maximisation to debt minimisation, particularly when falling share prices exacerbate the mismatch between their assets and liabilities. With all private sector actors all trying to save, only the public sector can boost aggregate demand. The state is ‘investor of the last resort', restoring the conditions necessary for profitable private investment to resume.

Thirdly, Britain and the US are poised for a ‘double dip' recession, while the rest of the EU lags not far behind. Financial markets, which had been rallying until last month, are falling again. As Nouriel Roubini recently argued, the ‘green shoots' of US recovery when examined closely are largely yellow weeds.

The USA and the Eurozone

The US economy is particularly important because it is the engine of the world economy, and Barack Obama's economic advisors understand the monetary and fiscal tools to use in a recession. But Obama's stimulus package is faltering: US retail sales, hourly earnings and employment figures for 2009 so far are worse than expected, the housing markets has not yet stabilised and new orders are down. The Dow-Jones appears to have peaked in June, and following June's payroll contraction is now firmly in bear mode again. Further stimulus is needed.

In the EU, despite the recent ECB injection of €440bn into the money market, the real economy continues to decline with retail sales looking poor and unemployment rising. The German model of export-led growth has fared particularly badly as financial contagion has reached world-wide proportions. As Paul Krugman said a few weeks ago in his lecture in London, unless Germany discovers a new planet to which to sell its goods, its economy will not recover soon. Rumours of further German banking losses continue to ebb and flow; a further fall in asset values would take even more purchasing power out of the German economy. And as everybody knows, when Germany catches a cold, the rest of Europe sneezes.

Beyond recession into deflation?

Three further features characterise the EU (including Britain). First, poor economic growth has slashed tax receipts, blowing large holes in government budgets everywhere.

Secondly, the worst-affected countries of Eastern Europe are being made to adhere to strict budgetary conditions for joining the euro, and drastic spending cuts are driving them further into recession and possible bankruptcy.

Thirdly, in May 2009 Eurostat reported Eurozone inflation (HICP measure) as zero, down from 3.7% 12 months earlier. Indeed, in a number of major Eurozone countries (Belgium, Spain and France) inflation was negative.

In short, looking beyond the near certainty of a prolonged recession (ie, 18 months or more), the spectre of Japanese-style deflation looms - as I first warned in an opinion piece on ‘stagflation' published here in June 2007. Once ‘deflationary expectations' set in, consumers postpone their consumption decisions hoping that goods and services will get cheaper. At the same time, the real value of household liabilities rises (ie, mortgage repayments become more onerous and foreclosures increase). In these conditions, banks become ever more cautious and firms postpone investment decision, thus making the situation even worse.

Brussels only knows microeconomics

The Eurozone's financial architecture is in desperate need of redesign. The French are quite right to insist on the reform of economic governance, even though - much like German fiscal conservatives - the Sarkozy government has been overly concerned with microeconomic issues of financial regulation rather than the macroeconomics of recession.

While it is true that greater prudential regulation of casino capitalism is needed, it is at least as important to recognise the crucial role of a pro-active macroeconomic policy, particularly when the eurozone lacks a coherent supra-national fiscal strategy. Automatic fiscal stabilisers at member-state level cannot get us out of this crisis.

Elsewhere I have argued - as indeed have economists like J-P Fitoussi in France, Paul De Grauwe in Belgium and Guido Montani in Italy, to name but a few - that the institutional arrangements of the Eurozone are uniquely conservative. Power is concentrated in the hands of a fully independent central monetary authority; a Competition Commissioner enforces economic liberalisation; fiscal policy is left to the member-states and constrained by the SGP; and ‘accountability' depends at union-level on a Parliament lacking the power either to shape the institutional arrangements of economic governance or to initiate policy.

Changing the game

It's time to change the rules of the game. The ECB can pour billions into the money markets, but the real economy of the Eurozone will not revive without active fiscal policy. Monetary policy alone is weak in a recession and cannot do the trick - the ‘liquidity trap' problem identified by Keynes.

Yes, European government deficits are growing, but this is largely because recession causes receipts to fall and transfer payments to the unemployed (‘so-called automatic fiscal stabilisers') to increase. And while it is true that cash-strapped governments will not increase their contributions to Brussels under current conditions, it is equally true that the Eurozone must have far stronger fiscal arrangements in place the next time recession rolls around.

A European Ministry of Finance (EMF)

It is absurd that there is a European Central Bank but not a European Ministry of Finance (EMF), particularly now that the SGP is in tatters.

A proper EMF would be funded by taxation levied on member states; it would be able to borrow abroad, issue its own ‘treasury bills' and collect the receipts from seigniorage currently held by the ECB. It would have a budget not of 1% of combined GDP, the current figure, but to 6-7% as originally envisaged in the 1977 MacDougall Report. It would have a counter-cyclical spending function (in contrast to the present rule requiring an annually balanced budget).

Moreover, the EMF would spend its money not on subsidising agro-business but on modernising and greening the EU's social and economic infrastructure, particularly in those eastern countries most in need. One day, who knows, it might help weld together the continent by rolling out a basic European pension payable to all citizens as an entitlement.

In short, it's time to rethink the sort of Eurozone we want when finally we emerge from the deepest recession in living memory. And it's time to make sure that this sad state of affairs does not occur again.

The writer is Research Professor at the University of London, SOAS (george@irvin.com) and author of Super Rich: the growth of Inequality in Britain and the United States, Cambridge: Polity Press, 2008.