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Home Publications Blogs Beat the Press Italy Is Back In Recession Because The European Union Is Defying Economic Logic

Italy Is Back In Recession Because The European Union Is Defying Economic Logic

Thursday, 07 August 2014 04:30

Students learn in introductory economic that Y = C+I+G +(X-m), which means that GDP is equal to the sum of consumption, investment, government spending and net exports. Those who remember their intro econ are not surprised to see that Italy has slid back into recession for the third time since the 2008 crisis.

Unfortunately simple economic logic does not find its way into the NYT article on the weakness of Italy's economy and much of the rest of the euro zone. The basic story is straightforward. Since 2010 the European Union has been demanding that countries in the euro zone reduce their budget deficits. This means cutting government spending and/or raising taxes. Lower government spending directly reduces demand in the economy. Raising taxes indirectly reduces demand by reducing disposable income, and thereby reducing consumption. (There is a supply-side effect from the change in incentives, but this is in almost all cases much smaller.)

In short, the European Union has been requiring that many of the countries in the Euro zone reduce demand in their economy. There is no obvious mechanism to replace this lost demand. If Italy, Spain, and other countries flirting with recessions had freely floating exchange rates it would be possible that the decline in the value of their currencies would lead to an increase in net exports (a lower valued currency would make their exports cheaper and imports more expensive), but since they are in the euro zone this route is not possible, except insofar as the euro falls against other currencies.

The high unemployment caused by the European Union's polices can have a modest stimulatory effect insofar as they push down wages in these countries. This can improve their competitive position relative to Germany and other countries with stronger economies, but this process is likely to be very slow, especially with inflation running at a very low rate in Germany.

In short, there is no plausible story whereby the countries of southern Europe can expect to replace the demand lost from the deficit reduction demanded by the European Union. The article should have at some point mentioned that the recession in Italy is pretty much exactly what most economists would expect from the European Union's austerity policies, just as physicists expect that when we drop a hammer it falls.


Comments (6)Add Comment
Internal devaluation.
written by Ralph Musgrave, August 07, 2014 5:58

Improving the competitiveness of periphery countries is not a side issue, as Dean seems to suggest. That desire / need to improve competitiveness of the periphery is the BASIC REASON for constraining demand in those countries, seems to me.

If the EZ as a whole was unnecessarily constraining demand because of a deficit fetish, then you'd expect to see high unemployment in Germany. But unemployment in Germany is not to bad compared to the US, UK, etc.
The Euro Defies Economic Logic
written by Robert Salzberg, August 07, 2014 6:33
The obvious, overarching problem is that countries that have the Euro as their sole currency defy economic logic. Our 50 states share a currency but as a nation we pay for Medicare, Social Security, Medicaid, infrastructure, SNAP, the military, homeland security etc.

No rational economist thinks that countries as economically diverse as the EU can maintain a monetary union almost completely based on a shared currency. The countries that maintained their own currencies along with the Euro are generally doing better, even Britain which embraced cruel and unusual austerity has had an easier time because they can borrow in their own currency.

The Euro created a fake boom in weaker countries that cannot be fixed with austerity alone. Austerity is lowering GDP, which increases the debt to GDP ratio and starves government investments, which lowers future GDP creating a downward spiral.

There are 2 alternatives to austerity. All Euro only countries could bring back their own currencies which would allow uneven inflation among EU countries. Or the EU could follow China and set the EU exchange rate directly to a basket of currencies or the dollar and deliberately cause higher EU inflation.

Ending the Euro as the sole currency in EU countries is the really the only logical, viable economic solution. Postponing the inevitable only makes things worse.
Austerians Continue to Fool Most of the People Most of the Time
written by Last Mover, August 07, 2014 6:38

It's too complicated. They can't - or won't - wrap their minds around the notion that macro economics literally works in the opposite direction of micro economics in a recession.

When everyone stands up to see the parade better, no one sees the parade better. When everyone spends less, everyone has less.

Regardless of the source of demand. Regardless of the national income accounting identity trade-offs between private savings, government deficits and trade balances. (However not regardless of whether the currency is sovereign, which if not can trap a country in a recession.)

It's a truism. Spending is either there or not there. Going on and on about excess government spending and debt is one thing. But to obsess over it in isolation, outside of a macro or international context is economic suicide when dealing with a recession.

Austerians have brainwashed the public that aggregate demand is equivalent to millions of households spending too much financed by debt way over their heads. Never mind adding up the components of aggregate demand to start the discussion.

Most of the public believes this most of time as they keep trampling over each other to see the parade better.
Euro Foresight Was 20/20
written by Robert Salzberg, August 07, 2014 7:07
Many prominent economists, including Paul Krugman, argued before the Euro was created that countries needed to maintain their own currencies to allow for uneven inflation between EU members.

The goal of a full monetary union is great but that must include the full merging of security and safety net programs within the EU.

It makes economic and political sense that the EU should begin by strengthening the economic ties they already share for security, finance, and infrastructure before moving on to sharing things like pensions, health care, and other safety net programs.

Eliminating individual currencies should be the last step in the EU monetary union, not the first.

It only worked in the U.S. because we were a young nation that needed to band together to achieve independence. In addition, at the time of the Revolution, barter and trade of goods and services was a much larger part of our economy. Even our Union was torn asunder by differences between the states in the Civil War and continues today to be torn apart by diametrically opposed views of governance in spite of our monetary union.
Balancing the Budget
written by John Wurm, August 07, 2014 6:45
Most understand a balanced budget. As part of the budgetary discussion, it must be made known the time to address high deficits is not during periods of low growth. High deficits must be addressed during periods of high growth.

A mechanism to address high deficits needs to be made part of the budgetary discussions. Something like, for each percentage point above 3% annual growth, taxes will be raised x% with this additional revenue to be used to retire debt.

Showing a path toward budgetary sustainability will alleviate fears.
Missing demand diagrammed
written by David Woodruff, August 08, 2014 5:11
This is a great summary. I have a chart showing how badly the Eurozone has failed to replace lost sources of demand here: http://politicaleconomyinpubli...model.html

The one thing I would add is that in fact exports and the trade surplus have boomed in some countries (eg Spain), even without an exchange-rate adjustment. But even with the export boom the scale of added demand is massively too small to make up for the effects of contracting domestic demand.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.