I ran across an interesting quote the other day on Economix (NY Times economics blog). It’s from a text by Casey Mulligan of the University of Chicago, entitled “The varying impact of austerity and stimulus”:
The interplay of the social good of helping the poor and providing them incentives creates tough policy choices for governments looking to reduce their deficits. The more resources available to those living below the poverty line, the less incentive they have to raise their income above that line.
More research is needed to quantify work incentives in various countries, but I suspect that Western European nations have been pursuing exactly such redistributive austerity and will continue to do so, which means that they can expect austerity to depress their economies.
He makes an excellent point on Eurozone dependency, coining a phrase 'redistributive austerity'. The welfare state strategy pursued by a majority of Europe’s economies before the onset of the crisis resulted in reducing incentives for low income groups to earn the additional income. This pan-European welfare state model was partially responsible for the current sovereign debt problem, since many nations’ governments offered concessions to various targeted voter groups in order to remain in power longer. The system of high debts, unbalanced budgets and rising CA deficits (inducing the so-called twin deficit problem) was used to increase domestic consumption instead of production which increased the vulnerability of the system to outside shocks. In addition, banking regulations that steered EU banks into financing the debts of peripheral nations, and thereby indirectly supporting this consumption culture, further increased the systemic risk of these economies (as I have pointed out in numerous occasions before). As for the redistribution point, one could argue of a misplaced set of incentives offered to the people, all under the scope of buying votes. This systemic dependency (domestic governments on foreign assets, population on government) added much to a decrease of productivity. And it is this decrease of worker productivity that needs to be addressed at in Europe. While most have called either for devaluation or internal devaluation (downward adjustment of real wages), productivity is best restored by a labour market reform that will rebuild the proper system of incentives in the labour market.
Mulligan’s viewpoint is that Western EU nations are still pursuing the same redistributive strategy, whereby nothing is being done to address the rouge incentives created to a large number of Europe’s population. Fixing these incentives is a painful solution indeed, but it is a necessary one in order to restore the right market signals that will guide private sector incentives towards growth creation. Any attempt of a stimulus or ‘redistributive austerity’ will only restore the pre-crisis status quo without addressing the fundamental institutional issues in Europe. The model applied in Europe so far has proved painfully wrong. It’s time to change it, and it’s best to do so during already miserable times. Why? Simple – have you ever heard of anyone attempting an institutional reform when the economy is growing rapidly? No one knows that this growth is unsustainable, and frankly, the short-term politicians don’t really care.