The Triumph Of Austerity (And Its Consequences)

Europe’s slowing economy is a wake-up call for the austerity-now folks. Industrial production in the euro-zone fell 2% in September, a sharp drop from August’s 1.4% rise, EuroStat reports. The annual pace is still positive, but a slowdown is evident here as well with September’s year-over-year rise of 2.2% vs. 6.0% in August. Germany is still the exception these days, enjoying far stronger growth than its neighbors. What accounts for the divergence? There’s no single answer, but an obvious place to start: interest rates. The high and rising rates outside of Germany are conspicuous, whereas German rates are low and falling.

As The Wall Street Journal reports:

Bonds issued by highly indebted euro-zone countries came under renewed pressure Tuesday, with traders demanding the highest yield premiums since the inception of the euro to hold French, Spanish and Belgian bonds instead of safe-haven German bunds, as they fretted over the ability of policy makers to push through tough austerity measures without choking growth.

Italian bonds also slumped, with the yield on the 10-year bond nudging closer to the 7% mark that in the past tripped Greece, Ireland and Portugal and forced these countries into seeking external assistance.

The U.S. economy is arguably in better shape, or so it appears, than the ex-German eurozone profile. But the slow-growth burden afflicts America too and so confidence is middling at best that the U.S. will avoid another recession. All of which suggests that calls in some circles for the Federal Reserve to switch to a hawkish monetary policy are misguided, to put it mildly. With economic growth still weak, unemployment high, and rising fears that Europe’s troubles will spill over into the U.S., the prescription for tighter money looks like the wrong policy prescription at the wrong time, at least for now.
Higher rates are ultimately the goal, but the path to tighter money is crucial. Ideally, higher rates should come as a byproduct of economic growth as opposed to premature central bank tightening. Europe’s currency crisis is effectively imposing a tighter monetary policy on the Continent outside of Germany with predictable results these days. Would higher rates in the U.S. bring a different outcome? Unlikely.
As for Europe, the austere German central bank isn’t helping alleviate the pressure, as the FT reports:

The president of Germany’s powerful Bundesbank has firmly rebuffed international demands for decisive intervention in the bond markets by the European Central Bank to combat the eurozone debt crisis, warning that such steps would add to instability by violating European law.

Bundesbank president Jens Weidmann told the Financial Times that only politicians could resolve the crisis, and he rejected the idea of using the ECB as “lender of last resort” to governments.

We’ve seen this movie before. Higher rates after a severe debt-deflation recession are burdensome, perhaps economically fatal. Hiding behind the excuse that we must fight inflation NOW requires a grand dismissal of economic history. There are times to impose austerity and don the hawkish posture, but there are times when that’s exactly wrong. This is one of those times, particularly for Europe.
Old lessons, it seems, must be re-discovered in the dismal science… again and again. As professor Roger Backhouse explains (and asks) in a recent book, this is The Puzzle of Modern Economics: Science or Ideology?.