Austerity confuses virtue with vice

2011-07-27

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Protests in Syntagma Square, Athens. Image Source: CNBC

The second rescue plan for Greece that was decided on the latest EU summit has many flaws which I explained in detail in a previous article. To remind you though of the main failure of the the new plan, it fails to understand the very structure of the crisis, which is a systemic crisis of the euro. The new deal treats the crisis as a Greek problem, thus continuing on the same failing rationale of the first bailout and of the ineffective “Fiscal Consolidation” policies (austerity policies) that have been implemented so far. The new deal massively fails to address the key issue of economic growth, which is the single most important step away from the crisis (do not be misguided by the euphoria that now exists in the markets – it will certainly be short lived).

What the new deal basically puts down, is a mechanism that will ensure liquidity for the Greek state and for the private banks. Liquidity that will not end up in the real economy though as the lion’s share will be given to pay back creditors and to recapitalize banks. Moreover the so-called “Marshall Plan” for Greece, is nothing more than a promising, but empty label, that has been given to a mere process of reallocation of community funds. The new deal is yet another step further into the realm of austerity that has so far worsened the crisis.

Austerity remains the main idea in this new deal for Greece (fiscal consolidation is a euphemism). Since “fiscal consolidation” (austerity) is still the primary aim of European leaders, it is worth putting down the mechanics of austerity amid a recession, to prove that austerity confuses virtue with vice.

Austerity of the sort that is practiced in Greece cannot save the country from default, as it only worsens the crisis, by increasing unemployment, thus decreasing aggregate demand and increasing unemployment benefits by the state. So aggregate demand falls and more people become unemployed, which means that the state will a) receive less tax revenue, b) it will have to assist more people with unemployment benefits (more spending), c) the state will have to increase taxes even further so as to maintain about the same level of income, d) it will fail to attract private investment, as in an environment of low demand (and increased taxes), no rational agent would invest. It is vain to expect supply-side growth in an economy with a constantly decreasing aggregate demand and with a highly uncertain business environment.

Make no mistake, the problem with Greece is its immense debt (that only relates to Greece – the crisis in Europe is systemic). But the only way to deal with a sovereign debt is to stimulate the economy, which will in turn bring in revenues. A growing economy does not worry as much about its debt, regardless of the size of it. The sovereign debt becomes sustainable once the government achieves economic growth that is above the interest rates that it has to pay back (this is also another failure of the new deal – 3.5% interest rate is still very high for Greece as the country doesn’t grow at all). Thus what a rational state should go for, is job creation, not job destruction, as it now does.
The above are wrapped up, in Paul Krugman’s statement:

Why not slash deficits immediately? Because tax increases and cuts in government spending would depress economies further, worsening unemployment. And cutting spending in a deeply depressed economy is largely self-defeating even in purely fiscal terms: any savings achieved at the front end are partly offset by lower revenue, as the economy shrinks. So jobs now, deficits later was and is the right strategy. </p>

Strict austerity policies massively fail to make the debt sustainable exactly because they fail to make the economy grow. They fail to create primary surplus (surplus without interest rates) that is necessary for making the debt sustainable, since the real economy becomes so depressed that the state cannot raise enough revenue from it. So even if the state spends almost nothing thinking that it will save money, in the end it will receive less revenue as the money coming from the real economy falls exponentially, since the economy shrinks as we now see in Greece.

The belief that strict austerity can fix the economy is a delusion. But when combined with an overt support to bankers (as is the case right now) at the expense of the well-being of the lower parts of the income distribution, then it is nothing more than class politics.

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