Choosing the best policy mix to cure Europe's stagnation.

• Author: Salin, Pascal
• Position: Essay

A great number of European governments have decided on austerity policies to reduce their fiscal deficits and public debt. In order to evaluate such policies, it is necessary to analyze the present and past economic situation of European countries, and to recognize the important role that savings plays in understanding this economic situation and possible future developments. After examining the economic background of austerity policies and the role of savings, this article discusses the choice of different types of austerity policies and policy mixes.

The Economic Background of Austerity Policies

The current economic situation of most European countries is the outcome of long-run eurosclerosis and the recent financial crisis.

Eurosclerosis

Countries that suffer from eurosclerosis are those in which there has been a low rate of economic growth and a high rate of unemployment for the last several decades. For instance, in France the annual rate of growth has been slightly higher than 3 percent only five times since 1980. The rate of unemployment has been higher than 7 percent every year since 1982, and often close to 10 percent.

Such a long-lasting situation may seem strange in a country with an open economy, a well-educated labor force, and entrepreneurial traditions. Only one possible explanation can be given to this state of affairs: misguided economic policies that prevent individuals from creating wealth. More precisely, high levels of taxation and a large welfare state, as well as innumerable regulations, especially in the labor market, have hampered efficient production and wealth creation.

The role of taxation is obvious: it destroys the incentives to work, innovate, save, mad invest. Indeed, the higher the tax rate, the lower the propensity of taxpayers to create wealth. In a system where there is a high level of taxes, it is like telling entrepreneurs: "Invest, produce, and hire workers. If you fail, you are responsible and you lose the whole of what you have done. But if you are successful, the state will take the greatest part of the wealth you have created."

The present tax systems are introducing a bias in the choice between the future and the present. They are dissuading people from saving because of the multiplicity of taxes on capital and because the income tax and VAT are based not only on resources that are consumed but on resources that are saved--that is, reintroduced into the economic circuit. It is also well known that a pay-as-you-go pension system does not induce individuals to save as much as they would with a fully funded system. In sum, the tax and welfare systems should be considered as important brakes to growth, because there can be no growth without accumulation of capital.

Regulations also play a negative role by decreasing the flexibility of markets and introducing an additional degree of risk (since the state can add new and paralyzing regulations at may time and in a completely discretionary way). Tiffs is particularly noticeable ha the labor markets. Thus, entrepreneurs become more reluctant to hire workers as it becomes more difficult to fire them whenever it is necessary or desired.

The Financial Crisis

It is in such a context that the 2008-09 financial crisis occurred, and it added a further cause of low--or even negative--growth and high unemployment. The mainstream explanation for that crisis stresses the fundamental instability of financial markets, the greed of traders and bankers, and the deregulation of the financial sector, but the true causes are quite the opposite (see Salin 2010). In fact, the main cause of the crisis has been the instability of monetary policy, especially in the United States (but also in Europe, Japan, and England). Interest rates have been very low and money creation very high in the beginning of the 21st century, inducing an artificial expansion of credit and malinvestment. The distortions introduced in the structure of prices and production called for a readjustment that came in file form of the financial crisis.

Of course, other causes contributed to the financial crisis. U.S. housing policy, which led to the subprime problem, played a major role, as did other misguided government decisions and practices. For instance, the role of the Federal Reserve in protecting banks deemed "too big to fail" encouraged risk-taking and leverage.

It is strange that for...