By Patrick Barron
The debate in Europe over what policies the debt ridden countries should pursue is being falsely constructed as a choice between austerity and growth. Not only is there another, more appropriate alternative, but these two alternatives themselves are not properly defined. The misconstruction of the euro has led to unsustainable debt levels. The simplistic alternatives offered are (1) cutting spending and raising taxes–the austerity option–and (2) even more monetary stimulus–the growth option–which promises that even more credit will stimulate an economy to higher levels of production from which debt can be amortized. These alternatives emerge out of a failure to understand why the countries are in debt in the first place and why previous credit injections have failed to ignite increased production. Therefore, if the problem is not understood, the solutions offered are likely to fail.
The Real Cause of the Euro Debt Crisis
The establishment of the euro led to lower interest rates, as there were explicit and even some implicit statements that no member of the euro zone would be allowed to default. This led to a classic case of moral hazard, whereby borrowers assume increased risk due to the promise that losses will be born either wholly or partially by others. The increased debt was supported by euro expansion by the European Central Bank, which monetized sovereign debt in a backdoor method. But rather than lead to increased profitable production, the profits of which could amortize the debt, the increased debt led to unprofitable, speculative investment and expansion of welfare benefits. There were no profits for debt amortization.
The original sin was a scramble for more euros, a classic tragedy-of-the-commons, whereby the debt guarantee created an unprotected common resource–the euro–for all to plunder to extinction. This fiat money credit expansion led to misallocation of resources that caused disequilibria in the structure of production. There were no real savings by real people, who preferred to sacrifice in the present for greater economic benefits in the future. In other words, individual time preference–the relationship of one’s preference for present vs. future goods–remained unchanged. This led to the economic crisis, whereby rising prices in consumer goods forced the abandonment of longer term projects due to lack of adequate resources for their profitable completion.
The commonly stated alternative solutions, austerity or stimulus, do not address the source of the problem. Austerity proponents offer increased taxation and reduced government spending to reduce the deficit. This is half right as far as it goes. Government spending must be cut, since this reduces the drain on resources from productive, private, and profitable uses to non-productive, unprofitable, government ones. But raising taxes diverts these resources right back to government. Growth advocates want even more credit expansion, which amounts to little more than a denial of cause and effect and a belief that more of the same somehow will produce a different result.
Indeed, growth is the key to solving the euro debt crisis, but it will not be the result of increased credit expansion. The first order of business must be to stop credit expansion in order to end the misallocation of resources that disrupts the structure of production and leads, instead, to economic contraction. This problem must be solved first, either through a rededication of the ECB to monetary stability (very unlikely, given the common ownership of the bank by irresponsible governments with a vested interest in monetary expansion) or through reinstating national currencies tied to gold. Then the governments must remove the barriers that stifle the components to real economic growth.
The Three Components of Real Economic Growth
Real economic growth derives from the application of (1)accumulated capital to (2) modern technology by innovative (3) management techniques. Technology, capital, and good management lead to greater productivity of labor, the only source of a higher standard of living. Of the three, technology is the easiest to acquire. But entrepreneurs need the freedom to use it in innovative ways, not restricted by laws that favor entrenched unions or by other so-call labor friendly regulations. The least understood component is capital. Capital is accumulated from savings, not from fiat credit expansion. Real people reduce their present consumption and invest their savings for a better future. Anything that inhibits savings must be eliminated. The interest rate must not be suppressed, so that savings is encouraged and rewarded. Government spending must be reduced so that taxation can be reduced. All manner of regulations on business must be eliminated. Property rights must be strengthened, so that investors will commit to long term projects and not fear future government predation. Entrepreneurs must have the freedom to buy goods and labor services from anywhere in the world with no tariffs or quota restrictions. With these liberal policies in place, the economy can grow and eventually help pay off the government debt mountain.
The governments of Europe have spent beyond their means and have tried to bridge the gap with increased debt. The promise that the debt can be amortized through further monetary stimulus has failed, because it led to capital misallocation and lower, not higher, economic output. Nor should governments raise taxes in order to balance their books, as championed by the austerity advocates. The real solution is an abandonment of monetary and fiscal interventions to be replaced with sound money and laissez faire capitalism in all its forms. There is no path to prosperity other than profitable work and thrift, which will lead to capital accumulation and greater productivity out of which the debt mountain can be honorably extinguished. The sooner the countries of Europe begin this process, the sooner they will return to real, sustainable growth.