It Ain’t Over ’til It’s Over

Update: just a link to Wolfgang Munchau, who seems to make a similar argument.

Austerity partisans had a couple of rough weeks, with highlights such as the Reinhart and Rogoff blunder, and Mr Barroso’s acknowledgement that the European periphery suffers from austerity fatigue.
In spite of the media trumpeting it all over the place, and proclaiming the end of the austerity war, it is hard to believe that eurozone austerity will be softened. Sure, peripheral countries will obtain some (much needed) breathing space. But this is neither a necessary nor a sufficient condition for a significant policy reversal in the EMU.

The problem is that there is no sign that core countries like Germany will finally let their domestic demand expand. And yet, this is what is needed. Look at the following figure, comparing the EMU and the US performance from the peak of the crisis to the latest available data (the last quarter of 2012):

What is this figure telling us? Many things, actually; but I’d like to point out just three:

1. The first is that while the US have recovered and are now above their pre-crisis GDP level, the EMU is still more than 3% below its level of January 2008. We are not going to see the pre-crisis level of activity for at least 2 or 3 years, as the Commission just revised downwards its (negative) growth forecast for 2013 (not surprising, and bound to be further revised, as the readers of this blog may know).
2. Domestic demand is down almost 6%, mostly because of investment (-19.1%).It makes no sense claiming otherwise: this is a Keynesian (sorry for the bad word; should I rate this post R?) aggregate demand deficiency crisis. On the contrary, in the US, robust consumption growth has compensated for the equally dramatic drop of investment, and as a result domestic demand is also above its pre-crisis level. As a sidenote, the dramatic decrease of investment makes one wonder what will be left of the EMU capacity to produce, once aggregate demand resumes.
3. The only two engines of growth, today are public consumption (!) and exports, both at around +4% with respect to the pre-crisis peak ; they compensate, unfortunately only partially, the dramatic drop in domestic private demand. Further reducing government spending, as will most probably keep happening, will lay the burden of recovery only on the external component. It is worth repeating that this small-country-syndrome, in the second largest economic bloc of the world, can only spell disaster. It is impossible to conceive a long-term reliance of our prosperity on demand coming from the rest of the world, as proponents of the “Berlin view” would like us to believe.

It seems very hard not to read from this figure that the EMU needs to seriously boost domestic demand, if it wants to break free from the recessionary spiral that is afflicting it since 2008. And once this is agreed, then it becomes clear why this talk about softened austerity at the eurozone level is pure nonsense. The eurozone is compressing public expenditure, while the private sector, downbeat or financially constrained, keeps expenditure stagnant. Countries that can afford it (hint: their longest river is called Rhein…) should increase their domestic demand. Not because they need to save those sinners in the periphery, but because of their size. No expansion of eurozone aggregate demand can happen without a reversal of policies in Germany.

Whether rebalancing will happen through higher wages (much needed), or increased public spending, is not for me to say. But unless Germany accepts to act as the locomotive of European growth and increases its domestic demand, giving one extra year for budget consolidation to Greece, Spain or Italy, will not end austerity. It ain’t over…