Euro fallacies

Many in the Eurozone are deeply frustrated that their diligent and rigorous attempts to cut government deficits and debt are not leading to restoration of growth and market confidence. They have taken to lashing out at the markets for being unfair and irrational. It is they that are being irrational. They hold two beliefs very dear to their hearts which dominate their thinking. First, that governments must aim to balance their budgets and keep debts low. Second, that it is the failure to do so that is the primary cause of the problems in Greece, Italy and Spain.

The first proposal is irrational because it fails to appreciate the important role that money creation by the issuer of a fiat currency plays in economic growth. Puts simply, only government deficit spending introduces debt free money into a currency zone, enabling the aggregated private sector to save. A system which does not permit deficit spending backed by the central bank creates a shortage of net financial assets. The only source of money in such an economy is commercial bank lending which is necessarily accompanied by debt creation. Any system in which private sector debt must increase to accommodate growth while net financial assets stay the same will eventually collapse.

The second argument is irrational because it should be obvious to any reasonable observer that increased government deficits were a consequence rather than a cause of the global financial crisis. Spain and Ireland are clear examples of this. Furthermore, efforts to cut these deficits and debts have made the situation worse in all the countries were it has been tried, including Greece, Spain, Italy, Ireland, and Portugal. How can one explain this if the deficits were the cause of the problem?

These deeply irrational ideas are based on economic thinking which has been thoroughly discredited several times in history, most notably during and after the Great Depression. They were resurrected after stagflation in the 1970's when poor analysis blamed the combination of inflation and high unemployment on excessive government spending. In fact they were the inevitable result of the huge increases in energy prices of up to 20 fold.

Here is a thought experiment. Imagine what an increase in oil prices to $1500 would do today. It would induce a combination of inflation and recession, which would continue until other prices had increased relative to energy prices, at which stage inflation would stop and growth would recover. That is exactly what happened in the 1980s.

Unfortunately monetarism and neoclassical economics wrongly took the credit for the recovery from stagflation and saw their influence restored, despite being thoroughly discredited by history. Control of the money supply was returned to commercial banks. This set the scene for the slow expansion of the giant credit bubble, it's bursting that resulted in the global financial crisis, and the Eurocrisis.

Hopefully these events will kill off these bad economic ideas forever. This may require a new generation of economists and politicians not subjected to brainwashing by neoclassical dogma. Change may require many funerals.