French and Greek voters have rejected Europe’s current macroeconomic framework. The headlines cry that voters demand growth rather than austerity. Yet growth is not a policy but an outcome. A vote rejecting the incumbents does not define the policy alternatives.
There are four main schools of macroeconomic thought. Keynesians focus on boosting aggregate demand through temporary budget deficits followed by a gradual return to budget balance as the economy returns to full employment. Free-marketers (confusingly called “liberals” in Europe and “conservatives” in the US) advocate business deregulation plus cuts in government spending and taxes to spur private sector hiring and investment. Deficit hawks emphasise budget cuts to eliminate the deficit and restore the government’s creditworthiness. Structuralists call for increased public spending paid for with tax increases rather than deficits, to increase the role of government in education, jobs and banking recapitalisation.
To put some names to these categories, Paul Krugman and Ed Miliband are Keynesians. Martin Feldstein and Mitt Romney are US free-marketers, joined by various Thatcherites and Hayekians on the continent. Deficit hawks include George Osborne, Angela Merkel, and Mario Draghi. I count myself among the structuralists and perhaps Francois Hollande will turn out to be as well. President Barack Obama has dallied with three of the four schools, all but the free-marketers, at different times calling for budget stimulus, deficit cutting and public investments.
The Keynesians are mistaken, I believe, on four counts. First, aggregate demand in practice is not a stable function of budget deficits as in the textbooks. Temporary tax cuts and increased transfer payments to individuals and local governments are often saved rather than spent; deficits undermine financial-market confidence. For both reasons, multipliers are erratic and can be close to zero.
Second, Europe’s double-dip recession has less to do with aggregate demand than with its zombie banks, a credit squeeze and the still-poorly defined role of the European Central Bank. Europe’s banks continue to deleverage, making the survival of Europe’s small-and-medium enterprises very difficult. Europe needs a bolder recapitalisation of its banking sector, but this requires more public financing and has been rejected by the budget wary politicians.
Third, the disappearance of manufacturing jobs also results from inadequate skills of much of today’s young people making them uncompetitive with low-wage Asia. The US and much of Europe (especially southern Europe) need a scaled-up programme of public investments in pre-school; education; job training; and active labour market policies. This is the essence of northern Europe’s path: train young people well so that they can compete internationally.
Fourth, the rising burden of public debt as a share of national income matters more than Keynesians acknowledge. Debt servicing is mounting and thereby squeezes out other vital spending by government. Capital markets know this as well and foresee the fiscal train wreck ahead following a “temporary” stimulus.
The free-marketers and deficit hawks also turn their back on our increasingly unequal societies. Children in poor households in the US and Europe can’t make it without public support. In the US, social mobility has collapsed: affluent households get their kids through college; working class and poor households do not. The budget and tax cutters also deny the vital role of public spending on science, technology and competitiveness.
Macroeconomic debates are mostly ideological rather than empirical. This is a shame. The diverse experiences across the OECD economies can clarify a lot about the various schools of thought. Of all the high-income countries, it is the northern European countries, including social democratic Scandinavia and the Netherlands, and social-market Germany, that have the most favourable combination of low budget deficits, high employment and global competitiveness. Of course the specific challenges and current conditions differ by country and so too will the best packages.
Northern Europe, including Germany itself, rejects the swingeing budget cuts that Chancellor Merkel has advocated for the rest of Europe. The northern European countries balance their budgets through high taxation, not low government spending. They use ample public outlays to ensure universal access to education, job training, and modern infrastructure. They insist on environmental standards, not environmental deregulation.
Ironically, Germany lives according to the norms of the social market but has preached rampant budget cutting instead. One reason is this: German politicians have refused to acknowledge the role of the unregulated German banks in creating Europe’s boom and bust. If they acknowledged the role of the German banks in this mess, the politicians would be under more pressure to recapitalize the banks.
Northern Europe shows that social democratic (or social market) structuralism – an active government that is socially oriented, environmentally friendly and skill promoting – works best. Scandinavia was also exemplary a generation ago when it decisively cleaned up its bank sector after an ill-fated cycle of liberalisation, boom and bust. Today’s tired debates between Keynesians and free-marketers greatly oversimplify the real options, especially now that banking reform, job training and inequality are the key issues. Perhaps Mr Hollande will facilitate a new growth orientation based on structural changes rather than a doomed flirtation with fiscal profligacy.