Wolfgang Schäuble, Germany’s finance minister, has defended Europe’s crisis management and launched a broadside against the critics and “doomsayers” in an article for the Financial Times (Ignore the doomsayers: Europe is being fixed).
In rejecting the position of the doomsayers, specifically those who thought and still think that the euro is a doomed project, he is correct. Critics of euro crisis management and doomsayers are not the same, however, and should not be confused. In fact the view that the euro is doomed and Schäuble’s defense, and what passes for his analysis, are both wrong. Having recently critiqued the doomsayers, it is important to explain why the incipient economic recovery in Europe does not vindicate the austerians.
Schäuble’s argument, in brief, goes like this. The European economy is recovering. This is due to the (painful and unpopular) structural reforms that have been implemented und the pressure of the EU/IMF/Germany. The fact that they work bemuses the critics and doomsayers, but that is only because they inhabit a “parallel universe”. In fact the euro crisis is only “contextually different” from the recoveries seen in places like the UK in the 1980s and Germany in the 2000s, where liberal reforms brought success. In the real world, so Schäuble, painful structural reforms work; it just takes time. Soft options, like stimulating demand, are wrong-headed and dangerous.
Almost all of this is completely wrong.
First, the euro area economy has it is true stopped contracting. Renewed economic growth is to be expected in the latter part of the year and going into 2014. Even the crisis countries are expected to see rising activity levels next year. This modest recovery remains vulnerable to shocks, for instance from a reemergence of problems in the banking sector. But let us assume that the recovery does in fact now materialise. The question is whether this counts as success. If in an economy we shut down one in five factories and offices – more or less the experience in Greece and some other crisis countries – we get an apparently strong recovery even if we put just one in ten of those workplaces back to work: growth of 2% would be recorded – but this conceals the fact that we have only recouped one tenth of the 20% loss of output previously suffered.
As I have pointed out on numerous occasions, the real issue is that the euro area, after entering and exiting the global financial crisis in line with the US, Japan and others, has massively underperformed compared with global benchmarks. It has thrown away the recovery that was in place from the middle of 2010, driving unemployment, which had fallen for one year, back up again. This was primarily a result of coordinated fiscal austerity policies and the lack of political will to resolve the sovereign debt crisis.
This is easily seen from the following graph which plots output in real terms since the first quarter of 2008. (Chain linked volumes, millions of national currency, Q!/2008 = 100; Eurostat data, own calculations).
Up to early 2011 the trajectory in the euro area and the US was very similar: from then on austerity in the euro area started to bite and interest rates shot up in the periphery due to failed crisis management. Since then output in the USA has increased by almost 6%. In the euro area it has fallen further, even including the recent upturn trumpeted by Mr. Schäuble. The British economy flat-lined over much of this period for a similar reason, despite aggressive monetary easing. And in Japan, too, it is clearly not structural reforms that explain economic developments. A sharp recovery was aborted thanks to the premature abandonment of expansionary policies (and a natural disaster); more recently, aggressively expansionary macroeconomic policies have brought about a notable turnaround.
Secondly, not only is Europe’s recovery, welcome as it is, belated and weak, largely thanks to the policies that policymakers such as Mr. Schäuble have consistently advocated. The fact that a recovery is taking place at all is not least a consequence of policy changes that he, and much of the German policymaking elite, fought hard against, and to some extent continue to do so. The two most important changes are the decision by the ECB to “do whatever it takes” (Draghi) to resolve the sovereign debt crisis (opposed, in particular, by Bundesbank chief Weidmann), and the postponement of austerity measures in the face of the overwhelming evidence about how much damage it was causing (a policy opposed, notably, by Jörg Asmussen, Mr. Schäuble’s former junior minister and now member of the ECB board).
Third, Schäuble’s equating of euro area “recovery” thanks to structural reforms and improved competitiveness with that of individual countries such as Germany and the UK is wrong-headed. It is possible for small open economies to regain price competitiveness through structural reforms (or other means, such as currency depreciation). Countries such as the Netherlands in the early 1980s and Denmark in the early 1990s managed this quite effectively and rapidly. In large economies like the UK and Germany it is already more difficult. The brutal neoliberal reforms in Britain did not materialize into above-average economic performance until at least ten years later: and that largely reflected the dramatic improvement in competitiveness that followed from the UKs expulsion from the exchange rate mechanism.
In Germany, wage moderation set in considerably earlier than the Hartz reforms: for many years the improvement in competitiveness was (more than) offset by the retarding effect of such wage moderation on domestic demand. Only in the immediate pre-crisis boom – not least thanks to Germany’s specialisation in machinery and high-end vehicles, given heavy demand from China and other industrialising countries, and from wealthy customers in Europe and the US, respectively – did the competitiveness effect prevail and German unemployment fall. Moreover, that competitiveness would have been compromised by a rising value of the D-Mark, had Germany not become a member of monetary union. A mere contextual difference this is not.
The euro area, though is a very different kettle of fish. It is a largely closed economy of more than 330 million people. Competitiveness is here a relative concept. The sort of reforms that Schäuble and other “structuralists” have in mind largely serves to improve the situation of one part of the monetary union against another: this is precisely what happened in the pre-crisis euro area. The rising trade deficits of countries such as Spain and Greece were very largely the mirror image of Germany’s rising surpluses. It is only a slight simplification to say that at the root of Germany and the euro area’s problems is that the economic policy elite – of which the German finance minister is a prime example – treats both as if they were small open economies that need to adjust to externally determined demand conditions, rather than large, rather closed economies that need to take their macroeconomic fate into their own hands, as the USA does, by setting macroeconomic policy in such a way as to ensure the fullest possible utilization of capacity.
Fourth, there is a question regarding the empirical evidence behind Mr. Schäuble’s assertions. He and other like-minded commentators claim – and presumably believe – that while Germany was busy reforming the countries worst hit by the crisis were expanding their welfare states, or burdening their economies with additional taxes and regulations. At the very least they failed to reform as Germany did. This question deserves in-depth research, but a quick and dirty first approximation is to consult the European Commission’s database of labour market reforms, LABREF. It enumerates all reforms conducted by countries from 2000 to 2010 in areas such as labour taxation, wage setting, unemployment benefits, employment protection legislation. In other words all those areas in which “structural reforms” are supposedly key to employment success.
According to the database euro area countries implemented a total of 1344 (!) such reforms in the nine years from 2000 to the crisis year 2008. The unemployment rate declined marginally over that period from 8.7% to 7.6% (EA17), but subsequently shot up to over 12% – despite additional doses of market-oriented labour market reforms. The unbiased observer could be forgiven for thinking that perhaps other things than supply side structures are key for unemployment (cf. my very first column for Social Europe). But what about country performance? Based on a simple headcount of measures the picture looks like this:
If you then map the number of labour market reforms up to the crisis, against the unemployment rate (I have taken the annual average for 2012) the picture looks like this:
You can immediately see from these two diagrams how Germany towers above the other countries in its reformist zeal and that the reformist laggards are now deservedly suffering much higher unemployment – provided of course you have the special-issue glasses the wearing of which is de rigeur for neo-liberal supply-siders and austerians. Those trusting their own eyes will take a different view.
It is obviously the critics of EU crisis management that inhabit the real world and the austerians and supply-sider who are stuck in a parallel universe. It is not microeconomic supply-side reforms that Europe primarily needs, but macroeconomic structural reforms that bring its economic governance architecture in line with the needs of managing an economy with one central bank but more than 330 million people that are citizens of 17 or so sovereign countries, each with their own economic and fiscal policymaking institutions. Here, some progress has been made. But it is not enough (e.g. banking union), in some cases misguided (e.g. fiscal compact, or the macroeconomic imbalance procedure). And, where it is positive, it has largely been achieved against the opposition of the German finance minister and those who share his mode of thinking.
The euro doomsayers are indeed wrong. On that I agree with the current German finance minister. But the belated, weak and still uncertain recovery in Europe has been achieved more in spite of, than because of him and his policies. Schäuble will very likely be replaced in a few days’ time. Much more doubtful, unfortunately, is whether his successor will have a better grasp of what Europe needs in terms of economic policy.
 Obviously this is rough and ready. Clearly not all measures are of equal importance. A sophisticated analysis would have to weigh the measures. This is no easy task however, and we do not need to assume that all measures are of equal worth to place some confidence in this simple approach: it is enough that the average “value” of the measures does not differ (much) between countries.
 It makes sense to allow for a lag between reforms and labour market performance. If I had added reforms from 2009 and 2010, for which data are available, and especially for more recent years, the picture would undoubtedly suggest that countries with more reforms had high unemployment. Of course, this would be to a considerable extent a case of reverse causation: high unemployment leads to more pressure for labour market reforms.