ATHENS – The International Monetary Fund’s belated admission that it significantly underestimated the damage that austerity would do to European Union growth rates highlights the self-defeating character of “orthodox” recipes to address the causes of the debt crisis that followed the financial crash of 2008-2009.
Conventional theory suggests that a single country (or group of countries) consolidating its finances can expect lower interest rates, a weaker currency, and an improved trade position. But, because this cannot happen for all major economies simultaneously – one country’s (or group of countries’) austerity implies less demand for other countries’ products – such policies eventually lead to beggar-thy-neighbor situations. Indeed, it was this dynamic – against which John Maynard Keynes fought – that made the Great Depression of the 1930’s so grim.
Today’s problems are compounded by a lack of sufficient private demand – particularly household consumption – in the advanced economies to compensate for demand losses stemming from austerity. During the last two decades, consumption drove these countries’ economic growth, reaching historically high GDP shares.
Moreover, major advanced economies, such as the United States, Germany, and Japan, face longer-term fiscal problems in the form of aging populations or oversize welfare states, limiting their capacity to contribute to demand management. Recent moves to ease monetary policy have been a step in the right direction; but, so far, they have not proved to be a game changer.