The Policy Error That Keeps Exacerbating Europe’s Structural Economic Problems

G8 party time.

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Paul Krugman thinks the European Union’s incantations about the need for structural reform are a distraction from their failure to manage aggregate demand appropriately. I think it’s worse than that. The European Central Bank’s tight money policies are actually a leading impediment to structural reform.

Think about something like the “bloated public sector” that everyone seems to agree Greece has. The problem with a bloated public sector is that you’re wasting real resources. People are standing around in make-work jobs that add little value to the public, when they could be doing something else. But that means that in order to reap the benefits of shedding bloat from the public sector, you need the conditions to be in place whereby the resources are re-employed. Tight money policies make that reallocation of resources difficult and undermine the whole purpose of structural reform.

More broadly, from a citizen’s standpoint, tight money undermines the basis of a reform agenda. If Europe had adequate demand throughout the continent, countries with very bad public policy in place would be experiencing tons of inflation while countries with better policy would see lower inflation and more real output. Citizens would look at the inflationary sectors in their economy and demand policy reforms that increase competition or allow for the introduction of new production methods. In a tight money paradigm, even the most mismanaged economies are shielded from the potentially inflationary consequences of bad policy, and instead what happens is people circle the wagons to defend the status quo in the name of saving jobs.

If you want a country like, say, Italy to reform, what you need to do is threaten to positively crush them with demand. Prices will soar unless you reform! And the best thing about this is that if you turn out to have made a mistake and actually Italy doesn’t need reform, then Italy will just get to enjoy a nice happy boom. Europe, by making adequate demand conditional on structural reform, has created a kind of recursive loop in which we don’t even have any way of telling whether countries are pursuing needed reforms or not. Everything simply hinges on the semi-arbitrary judgments of Frankfurt and Brussels about which reforms are the most important.