IMF debunking of the German View’s austerity stance comes too late for Greece

The German View argues that for the euro zone to thrive, those members must accept further misery by cutting wages and prices at home.

The IMF has put to bed the German View.

The German View is a hypothesis about monetary unions: that in the euro zone, economically depressed members need to cut wages and prices for them to grow again.

The German View argues that for the euro zone to thrive, those members must accept further misery by cutting wages and prices at home.

Then investors will flock in to take advantage of cheap labour and asset prices, and the country’s exports will cost less in international markets. Exports and inward investments will grow and the economy will thrive.

This is the economic position that has been imposed on Greece.

But now the IMF is saying that it’s junk.

The IMF is not alone in this. Plenty of people have been saying this for some time.

If you have a crisis-hit country and you further depress economic activity in that country by cutting wages and reducing government spending, you are likely to make things worse.

The German View argues that this is counteracted by increased demand from outside the euro zone.

But if, as has happened in the euro zone, many countries attempt to lower labour costs all at once, external demand doesn’t increase sufficiently to encourage firms to take advantage of lower asset and labour costs.

In Greece, the prices of assets and exports don’t become cheaper than those of Germany’s, so Greece doesn’t sell more exports or attract more investment than Germany. Greece is just made worse off by cutting input costs.

So internal demand doesn’t increase because all the Greek consumers are worse off. Demand from the euro zone doesn’t increase because euro-zone members are also cutting demand. And demand from outside Europe doesn’t increase because Greece isn’t cheaper than Germany.

If everyone rushes to make themselves worse off, economic activity isn’t going to increase.

This has happened: so the Greek programme of internal devaluation is doomed to failure. And that’s before the human cost of cutting wages and prices is observed – an estimated 25 per cent nominal cut in wages between mid-2013 and late last year. This, it turns out, is pointless suffering.

That’s the main argument made in an IMF staff discussion note that was released yesterday.

It’s why economists have called for Germany, the continent’s largest economy, to adopt expansionary policies in a bid to serve as the region’s motor of growth.

But German officialdom does not see things this way.

The chief economist of Germany's finance ministry, Ludger Schuknecht, wrote in the Financial Times on October 5 that Europe's problem was that it still had too much debt.

Everyone should pay down debt instead of consuming things or investing, he argued. That builds “resilience” into the economic system, which leads to “confidence”, which leads to growth (because “confidence” outweighs the fact that people are tangibly worse off because of lower demand).

The circular flow of income determines the welfare of a country. My expenditure is your income; and your expenditure is my income. If everyone spends more, everyone has more income.

Debt complicates the picture because it consists of an injection of income at a current point in time, in exchange for a withdrawal of income at a later date.

If everyone withdraws money now, income is lower, so expenditure is lower, so people are worse off.

Sometimes having too much debt might reduce the ability of companies to engage in economic activity. For instance, if banks are forced to buy up huge amounts of government debt, they may not lend to small businesses, which is one way in which economic growth happens. Or negative inflation may trap companies in a cycle of increasing nominal debt.

Advocates of austerity have to tell an explanatory story about debt in which reducing spending through debt necessarily has more of an impact than the definite loss of welfare from everyone cutting spending at once.

This is very hard to do. We know that cutting expenditures hurts growth, usually by more than the amount cut. Paying down a debt pile, however, does not by itself improve anyone’s welfare.

Mr Schuknecht’s argument – that lower debt unleashes confidence, which unleashes growth – is a familiar right-wing trope.

Why would consumers and companies feel more confident despite having wages and earnings cut? And why would this psychological state do more to boost their spending than, say, having bigger wages and earnings? The Nobel laureate Paul Krugman talks about the “confidence fairy”. Right-wingers since Reagan have argued that their preferred policies would boost economic growth via the intervening causal variable of confidence.

It’s unpersuasive because we are expected to believe that “confidence” outweighs actual decreases in people’s welfare. But it’s not clear how this could happen – except, perhaps, if a fairy were to intervene. At least now, the IMF officially disagrees with this view – almost, but not quite, a decade too late for Greece.

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