The euro zone is a 'failed experiment'

Euro Zone: Leaders are adept claiming credit and shirking blame but if the world economy and euro zone in particular are to have any chance of recovery they must act.

The euro-zone crisis is a predictable result of the main European countries’ deliberate policy of repressing aggregate demand. Louisa Gouliamaki / AFP

Politicians are masters at passing the buck.

Road to ruin or recovery?

Euro Zone The National charts Europe's struggles as it attempts to through of financial crisis. Learn more

Everything good that happens reflects their exceptional talents and efforts; everything bad is caused by someone or something else.

The economy is a classic field for this strategy. Three years after the global economy's near-collapse, the feeble recovery has already petered out in most developed countries, whose economic inertia will drag down the rest. Pundits decry a "double-dip" recession, but in some countries the first dip never ended: Greek GDP has been dipping for three years.

When we ask politicians to explain these deplorable results, they reply in unison: "It's not our fault." Recovery, goes the refrain, has been "derailed" by the euro-zone crisis. But this is to turn the matter on its head. The euro-zone crisis did not derail recovery; it is the result of a lack of recovery. It is the natural, predictable, and (by many) predicted result of the main European countries' deliberate policy of repressing aggregate demand.

That policy was destined to produce a financial crisis, because it was bound to leave governments and banks with depleted assets and larger debts. Despite austerity, the forecast of this year's UK structural deficit has increased from 6.5 per cent to 8 per cent - requiring an extra £22 billion (Dh126.54bn) in cuts a year. David Cameron, the prime minister, and George Osborne, the chancellor, blame the euro-zone crisis; in fact, their own economic illiteracy is to blame.

Unfortunately for all of us, the explanation bears repeating nowadays. Depressions, recessions, contractions - call them what you will - occur because the private-sector spends less than it did previously. This means its income falls, because spending by one firm or household is income for another.

In this situation, government deficits rise naturally, as tax revenues decline and spending on unemployment insurance and other benefits rises. These "automatic stabilisers" plug part of the private-sector spending gap.

But if the government starts reducing its own deficit before private-sector spending recovers, the net result will be a further decline in total spending, and hence in total income, causing the government's deficit to widen, rather than narrow. True, if governments stop spending altogether, deficits will eventually fall to zero. People will starve to death in the interim, but the budget will be balanced.

That is the crazy logic of current economic policy in much of Europe (and elsewhere). Of course, it will not be carried through to the bitter end. Too much will crack along the way - the banks, the monetary system, social cohesion, the legitimacy of the political regime. Our leaders may be intellectually challenged, but they are not suicidal. Deficit reduction eventually will be put into cold storage, either openly, as I would prefer, or surreptitiously, as is politicians' way. In the UK , there is already talk of Plan A-plus.

Those who see the need for such a growth strategy, but who also want to help their friends, like the idea of tax cuts - especially for the rich. This knocks a hole in current deficit-reduction plans but, provided government continues to cut spending, it has the benefit (from a conservative's point of view) of shrinking the state's role over time.

Apart from questions of fairness, cutting top tax rates is an inferior way to increase spending, because the rich have a higher propensity to save. Tax reductions should be targeted specifically at the poor if one wants the money to be spent to stimulate the economy.

In fact, the best option of all is for the government to spend the money itself. Governments can do this consistently with a medium-term deficit-reduction plan by making a crucial distinction between their budgets' current and capital accounts. The current account covers spending on services and perishable goods that produce no assets. The capital account is for buying or building durable assets that give a prospective future return. The first is a charge on taxation; the second is not.

A separate entity could do the investing. A national investment bank would be capitalised by the government, borrow from the private sector, and invest in infrastructure, housing, and "greening" the economy. This would simultaneously plug a hole in demand and improve the economy's long-term growth prospects. There are signs officials in the UK and the US are starting to move in this direction.

If nothing works, it will be time to sprinkle the country with what Milton Friedman called "helicopter money" - put purchasing power into people's pockets by giving every household a spending voucher with an expiration date. This would at least keep the economy afloat pending implementation of a longer-term investment programme.

It would be better if such schemes could be agreed upon by all by Group of 20 leading and emerging economies. If not, groups of countries should pursue them on their own.

The EU desperately needs a growth strategy. Its current bailout schemes only help countries such as Greece and Italy to borrow money cheaply in the face of prohibitively high market interest rates, while the schemes' insistence on more budget-deficit reduction in these countries will reduce European purchasing power further. The recipient governments will have to cut their spending; the banks will have to take large losses.

The euro zone must be recognised as a failed experiment. It should be reconstituted with only countries that do not run persistent current-account deficits. Everything else proposed to save the euro zone in its current form - a central treasury, a monetary authority that does more than target inflation, fiscal harmonisation, a new treaty - is a political pipe dream.

(Robert Skidelsky, a member of the British House of Lords, is professor emeritus of political economy at Warwick University).

* Project Syndicate

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