Austerity is the curse of our time. Governments cut spending, raise taxes, reduce employment and lower wages in the hope of better times. The consequences are dire. 26 million people are unemployed in the European Union. Youth unemployment is 6 million, in Spain and Greece more than 50 percent.  A whole generation is desperately seeking work. In 2010, 115 million people in the EU27, or 23.4% of the population, were at risk of poverty or social exclusion and the situation is getting worse. This cannot go on. Even European Commission President José Manuel Barroso has now warned that “public spending cuts alone will not solve the European financial crisis”. And the German chancellor Angela Merkel has understood that power comes from controlling language: “Everyone else is using this term austerity. That makes it sound like something truly evil. I call it balancing the budget.”  Leaving this Orwellian newspeak aside, I prefer to talk about growth: growth creates jobs; growth increases income; growth, in other words, is (nearly) all you need.
But how can Europe return to growth? Unfortunately, there is a lot of confusion about the meaning and drivers of economic growth. This makes the proper design of policies difficult. When economists refer to this concept, they usually think of steadily expanding economic productive capacities, due to the increasing use of labour, capital and technological progress. These supply-side factors determine the amount of output an economy can produce. Long run economic growth depends, therefore, on so-called “structural” factors, which determine whether resources are allocated efficiently, whether the potential capacities are fully used, and whether the efficiency of the economic system improves. When distortive regulations prevent firms from combining labour and capital optimally, economic growth will suffer. When women cannot seek employment, because there are no facilities to take care of their children, or when governments cut spending for schools and higher education, growth is not as high as it could be and total factor productivity is hampered for decades. When research and development remain underfunded, the essential sources of long run growth dry out.
In Europe, there are clearly many deficiencies in the productive capacities, and not only in the south. Even the much admired model of Germany’s market economy (it hardly deserves the adjective “social” any longer) has only grown its economic potential on average by 1.1 percent per year since 1999, compared to 1.6 percent in the UK and the United States, or 3 percent in Slovakia and Poland. Even Greece has done better with 1.4 percent, despite the tragedy of the last 5 years. Only Italy (0.6%) and Portugal (0.8%) have performed worse than Germany. Thus, there can be no doubt: Europe needs structural reforms to improve its growth potential. It needs investment in people, infrastructure and capacities. And it needs smart growth, which minimizes the use of scarce and non-renewable resources. But this is not what conservative politicians mean when they talk about “structural reforms” that make labour markets more ‘”flexible” and abolish regulation. They think of how to make more profit.
However, when people on Europe’s increasingly more vociferous left are demanding governments to stimulate economic growth, they also have other things in mind than improving the long run efficiency of Europe’s economic potential. They focus on short-term increases in GDP at a time when incomes are falling. They want more effective demand.
They have a point. For there is a simple measure that indicates when demand is insufficient to absorb the potential supply of an economy and it sends a clear message. The measure is the output gap, i.e. the difference between actual GDP and potential output as calculated from a production function that assumes all resources to be fully employed. When the output gap is positive, demand exceeds supply and there are inflationary pressures. In that case, some austerity may actually be a good thing, for it avoids a deterioration of price competitiveness relative to trading partners. But when the output gap is negative, as it is now, economic capacities are larger than what people are willing or able to buy. Because markets do not absorb the potential output, investment and growth will slow down. During the first decade of European monetary union, more austerity would have been the right policy in southern euro member states like Italy, France, and Spain, but also in the UK, Sweden and the United States. By contrast, Germany would have benefitted from higher demand, because its output gap was negative. However, all that changed in 2008 after the Lehman collapse. Figure 1 shows the dramatic drop in actual GDP subsequent to the global financial crisis. Output gaps turned deeply negative everywhere. Only Germany, Sweden, Estonia and very slowly also the United Stated have by now closed the gap. In all other European countries actual output has remained far below the potential.
In 2009 all G20 governments therefore agreed that stimulating effective demand by public borrowing was necessary. The stimulus worked. A sustained depression was avoided. But as soon as the world started to pull out of the global financial crisis, Europe was shaken a second time by the Greek debt crisis, which turned into a full-fledged Euro crisis. While the Obama administration started fiscal consolidation only very gradually, European policy makers responded to the Euro crisis with radical austerity. It did not work. The early exit from active demand stimulating policies has pushed Europe into a double dip recession.
However, there is more to austerity than insufficient demand. The economic literature usually interprets output gaps as a cyclical variation around a long run growth trend, which is determined by labour and capital input and technological improvement. These theories assume that the economy’s supply side is exogenous, and aggregate demand has to adjust. For new classical economists this adjustment happens automatically if markets are allowed to operate flexibly; for Keynesians some demand management by means of monetary and fiscal policy is required to minimise the output gap. However, the crisis teaches us that both these approaches have missed the fact that the supply side may respond endogenously to demand conditions.
Demand management is not just a matter of avoiding cyclical variations around the long run trend of a steadily growing economy. It is also about generating an environment with incentives for productive investment and entrepreneurial initiative, so that demand management contributes to the long-run development of the supply side. A negative output gap (i.e. a lack in demand relative to potential output capacities) will affect the rate of investment and the development and adaptation of technological innovation as well. By contrast, a positive output gap ignites inflationary pressures, and they will be met by restrictive monetary policies which will also reduce investment and growth. Thus, the best condition for economic growth is that demand and supply are in balance. This is what economic policy should aim for.
Hence, aggregate demand will affect future potential output through two channels: a negative output gap indicates insufficient market opportunities leading to lower investment and less output in the future, especially when the demand gap persists for a long time. On the other hand, a positive output gap means demand exceeds supply, so that prices go up. This may generate some investment in the short run, but if inflation is repressed (as it should), the effect will be short-lived.
To test whether this hypothesis of a long-run reduction in the potential growth rate due to insufficient demand holds up, I have estimated a panel regression for Euro Area member states, where the potential growth rate, and the investment rate are dependent on the cumulative positive and negative output gaps. I have also added the GDP deflator and separated periods with positive and negative cumulated gaps.
The results in Table 1 support the hypothesis. Prolonged negative output gaps in the Euro Area will reduce potential GDP, because the lack of demand will disincentivize investment. This phenomenon is less clear for the 1990-2012 period, which is dominated by many structural reforms due to the creation of the European internal market. However, for the monetary union era 1999-2012, the model is well supported by the data: a negative cumulated output gap lowers the potential growth rate, while structural reforms increase capital accumulation and raise the growth potential. Investment is the channel through which this effect is generated. Inflation does not matter, presumably because the ECB has been successful in maintaining price stability and this may also be the reason, why positive output gaps do not generate higher growth: because excess demand generates inflation, it will be countered by higher interest rates, which reduce investment and potential growth.
I conclude that there is significant evidence for the long lasting negative effects of austerity for European economic growth. The lovely story told by conservative policy makers that painful reforms today will guarantee a bright future tomorrow is wrong. When inflation prevails, austerity is good. But when demand is lacking, austerity is bad. It is bad in the present and it is bad for the future.
The conclusion is clear: European economic policies must change. Austerity must be stopped, but injection of demand in itself is not enough for better living standards in the future. Stimulating demand is, however, a necessary condition for future growth. How we can stimulate demand in the Euro Area will be explained in my next column.
 I thank Piero Esposito for research assistance.
 The negative gap is expressed in absolute terms so that a negative sign signals that an increasing negative gap will reduce potential GDP.