Europe’s decisive moment

The moment of decision is at hand for Europe. Depositors are beginning to pull out their euros from banks in Greece. At the same time, the entire banking sector in Spain is at serious risk due to toxic assets. The grave danger of a banking collapse in both Greece and Spain has appeared amidst the deepening recession wherein there is 22 per cent unemployment in Greece (50 per cent amongst the youth) and 25 per cent unemployment in Spain. What may be undermining the confidence of depositors in these two countries — and, therefore, hastening a banking collapse — are two immediate concerns: first, the fact that the available European bank bailout fund at 780 billion euros is insufficient to bail out both Greece and Spain (the Spanish banks alone hold 2.3 trillion euros of deposits) and second, the continued pressure by the European establishment and the IMF on Greece to implement austerity measures, which its government and people are manifestly unable to bear.

The insistence by German Chancellor Angela Merkel on austerity measures in the face of what has now become a Great Depression, and the diplomatic attempt by President Barack Obama to introduce a growth initiative in Europe at the recent Camp David Summit, can be understood in the context of the ongoing debate between two schools of thought in economics: the neoclassical and the Keynesian. In terms of its theoretical underpinnings, the present debate echoes the one that took place during the first Great Depression in the 1930s between the classicists and John Maynard Keynes.

The classical view was based on a belief in the efficacy of the market mechanism, which led to prescribing a policy of non-intervention by governments (laissez-faire). Their argument was that the level of employment is determined in the labour market and, hence, if wages were allowed to fall, employment would increase to end the unemployment crisis. Yet, unemployment continued to rise even as wages fell. Keynes changed the paradigm by postulating that the level of employment is determined by the decision of capitalists to invest. If they perceive that they will not be able to sell their output to earn a profit, they will refrain from investing, thereby triggering underutilisation of productive capacity and unemployment. The associated policy suggestion was that the gap between the investment required to achieve full employment and that being made by entrepreneurs ought to be filled through government expenditure. The Keynesian school won the day and Europe was pulled out of the Great Depression.

In this, the second Great Depression in Europe — like the first in the 1930s — the explanation by the opposing schools for the economic crisis is distinctly different, as are the policy prescriptions. The neoclassical argument is that loose monetary and fiscal policy in the years preceding 2008 allowed cheap money to be pumped into risky financial assets, particularly house mortgages, to create an asset bubble that finally burst. This created a crisis in the financial sphere, which quickly morphed into a crisis in the real economy. By contrast, the Keynesian argument traces the crisis to the earlier accumulation of savings in East Asia, which were not sufficiently matched by new investment in the US. The Keynesians argue that it is a lack of an inducement to invest in the real economy by entrepreneurs that has caused the Depression. President Obama tackled the crisis through repeated injections of government expenditure (‘stimulus packages’) and managed to achieve an economic turnaround — albeit, a fragile one — in the US economy. It is this nascent economic recovery in the US that could be pulled down by the contagion effect of a catastrophic collapse of the European economy following disintegration of the eurozone.

The lesson of the present Depression, as indeed of the one in the 1930s, is: markets are not self-regulating. In this eleventh hour, the European economy can be pulled back from the precipice if policymakers moderate austerity, put up the money to guarantee bank deposits, pledge for joint funds to recapitalise ailing banks and change the composition of public expenditure towards productive investment. Start the process of economic recovery.

Published in The Express Tribune, June 18^th, 2012.