EZ problems and Contagion

Contagion today is causing even the ‘core’ European countries to be affected by investors’ fear of the EuroZone (EZ) crisis, causing a mass selloff of EZ bonds which has caused the spread for French yields over German Bunds to hit a record high, and the Euro to fall. Even the stable Scandinavian countries, like Finland, are starting to get affected.

More than ever, it is fundamental to distinguish what is really happening from the hype. As I have argued before, it is not true that Italy has lived beyond its means. It is a pretty prudent country, with high private savings, and the deficit not that bad at 4% of GDP. The debt/GDP ratio is indeed very high at 120% (not much higher than when Italy joined the Euro), but this is due to its abysmal growth rate which has been below the interest rate for too many years.

Italy’s problems are not recent: it has had 15 years of low growth, only Zimbabwe and Haiti have grown less. And ironically this is not due to its ‘financial irresponsibility’ (or "La Dolce Vita") but to the opposite: it has not spent enough in the right places. Italy’s terrible productivity figures are a result of it not having invested enough in those areas that increase productivity, like human capital formation, R&D, science-industry links etc. And of course factors like corruption, tax evasion, and the lack of meritocracy has made all that worse. But increasing meritocracy, for example, requires an increase in investment: e.g. investing in those areas that increase expertise and professionalism (lacking in many areas) and rewarding the good performers with higher pay (school teachers are increasingly badly trained, and earn only 1200-1400 Euros per month). How will freezing public sector pay help meritocracy in education?

In fact, no matter how good Mario Monti is (and he is good), the austerity budget that Italy is being forced to swallow has very few measures that will increase growth. Pension reform, freeze of public sector pay, rise in health fees, cuts to regional subsidies, increase in VAT— most of these measures will simply decrease demand, due to the fall in standards of living which has also plagued the UK economy. None will increase productivity and dynamism, leading to new high quality products and services, so badly needed.

But due to ever increasing contagion today, other countries like France and Germany, which unlike Italy have been investing in the right places (both countries have in fact increased their R&D spending after the crisis as a signal of where they think growth will come from), are being affected. Germany and Finland are indeed the two countries in Europe that are leading in investments in what is surely to be the next big thing after the internet: Green Technology. And they are doing this because they recognise that China’s global growth lead is not just due to the exchange rate question, but also due to the right investments it is making in this new sector that will soon (not yet) bring very high returns.

But the crisis is getting worse. And this is because the same financial markets that have caused the ‘financial crisis’ are now dictating the policies of companies, nations, and transnational bodies like the EU, which should instead be thinking about the ‘growth crisis’. It has been the short-termism of financial markets that has caused companies to focus on boosting their stock price, via practices like share buybacks, rather than the long-run investments that increase productivity and innovation. It was the logic of private equity investors and hedge fund managers that allowed companies but also countries like Italy mask their risk profile behind shady products and figures. And it is badly structured credit ratings, which focus only on short-term financial measures of performance, that cause some of the most innovative small companies to fail to get bank loans—choking off the recovery. And it is financial markets that have caused inflation, a natural consequence of a growing economy, to become one of the chief targets rather than growth. In fact, the only developing countries that have had remarkable growth records are those that put growth investments above the austerity concerns of the IMF. And the irony is that the EU is now going to them begging for help (e.g. Brazil, China).

Why are we therefore allowing these same financial markets to tell us which countries are in trouble, and more importantly, dictate the solutions. Italy is not Greece, and France is not Italy. Each one has different problems with different solutions (Italy unlike Greece has a serious industrial sector, and France, unlike Italy, has been spending on areas that increase productivity like R&D). And yet now they are all going under. Even Finland!

Joe Stiglitz once said that the economists who work in the World Bank are the rejects from Ivy League economics departments, and are ignorant of local problems so cut and paste the usual neo-liberal recipe from Argentina to Poland, completely ignoring the specific problems in question. Well, given that it is this same neo-liberal logic is being applied to European countries, it is no surprise that we see the same ignorance. Austerity WILL NOT solve the problems of countries like Italy that have not made enough smart investments. In fact, such plans will surely make it a permanent part of the emerging ‘periphery’.

What is the solution? Monetary and fiscal policy must not only be strengthened at the EU level, but also be thought about together. Not only must the ECB finally act like a proper central bank, overcoming the German fears of inflation (which are greatly exaggerated in a moment when there is under-utilized capacity all over Europe). It is fundamental that the bailouts that occur (both through the European Financial and Stability Facility and the bond purchases of the ECB) do not simply increase the coffers of the banks which then don’t lend the money (a core characteristic of the crisis). Rather, these measures should be directed at the particular solutions needed by the particular countries in question. This must be done with active agreements, and perhaps contracts, between the ECB and the Presidents of the individual countries In Italy, this discussion must be had by the two Marios (Draghi and Monti), making the real debate be how to make sure that the increased money supply finds its way to increasing those investments that have been completely ignored during the ‘distracted’ Berlusconi decade: education, research, human capital formation, training. And measures should be introduced so that companies that engage with such investments should be rewarded rather than penalised. This is a difficult task, but the only one that will turn the situation around and allow the real problems and questions of the EZ to be discussed rather than obsess around the short run concerns of financial markets which have a poor record of solving growth problems.