A good mood based on a bad policy

The sudden turn in the mood in Europe regarding the prospects of the global economy needs commenting. In this context, most European governments announced drastic cuts in government expenses in an effort to avoid following Greece to the precipice of default. It coincides with the outcome of the G20 deliberations a few days ago that dropped support for fiscal stimulus and emphasized the risk of having sovereign debts getting out of control. This turn is happening in an environment where the politicians seem to be incapable of directing stimulus to productive directions, while at the same time, the public continues to reject any tax increases to cover the future deficits that today’s stimuli may create.

The critical issue is whether we need more and cautiously directed stimulus to enable the global economy to retain current economic activity, or whether we need a fiscal exit. Nobody would disagree with safety nets or government support to post-secondary education, investment in clean energy and new transport infrastructure. After all, these are all Keynesian measures indeed. Keynes never claimed either that his proposed policies can provide deleveraging overnight, or that they can correct the excesses that “Madoff economics” and unregulated markets usually bring about. But Keynes’s way might make deleveraging smoother and with the least possible negative repercussions, especially if appropriate monetary accommodation complements systematic spending.

As for Greece, the main problem is the absence of an appropriate domestic monetary and exchange rate policy combined with an extremely hard euro, which eroded domestic competitiveness and increased demand for imports. The result was a ballooning current account deficit that reached 14% of GDP in Greece (2008), a deficit that requires corresponding capital inflows. These inflows could not be foreign direct investment in the context of falling domestic competitiveness. The government, thus, had to take over and sell bonds to finance a fast-deteriorating current account as the hard currency was fueling domestic consumption by making imports cheaper and more competitive.

In sum, if a contractionary, “post-Great Recession” era policy finally prevails globally and especially around Europe, Greece and similar countries might find it even harder to drive their economies through an export-led recovery. It would then be easy to predict what will happen to those banks keeping toxic skeletons in their closets.