Some readers will recall a time in 1988 when it was claimed that the value of a few square kilometres of real estate in Tokyo exceeded the assets of the US state of California.
The bursting of the Japanese property bubble brought with it a similar credit crunch, and fearing the worst, Japanese households cut their spending thus sending the economy deeper into recession. The Bank of Japan initially did the right thing, flooding the market with liquidity and holding nominal interest rates close to zero. But in the early 1990s, price levels started to fall—causing consumers' nominal debt to rise in real terms and leading them to postpone consumption even more. The result was nearly two decades of stagnation. As Keynes recognised, there comes a point when the use of monetary policy alone is as ineffective as 'pushing on a string'.
The fourth point—following logically from the third—is that Keynesian fiscal policy is very relevant today. Ultimately, when nobody else is willing to spend and when credit is tight, it is government which must spent its way out of the crisis. This was the lesson of the 1930s and 40s, the lesson in Europe of Marshall and the the trente glorieuses, the lesson of Japan, and it is still the lesson today. But Europe has been vulnerable to stagnation for the past decade.
Why Europe is vulnerable
Lest Europeans should think themselves smugly superior to America in terms of economics (we after all have not engaged in sub-prime lending), the reader might ponder the ECB's current obsession with inflation.
True, oil prices are rising and food is dearer (particularly in the world's poorest countries), but to raise interest rates in the face of impending recession as the ECB has recently done is little short of economic madness. Oil prices are high because of growing uncertainty about the future of the Middle East; food prices are high in good measure because of switching agricultural land to biofuel crops. Tighter money in Europe may squeeze household demand, but it will not help resolve the underlying causes of inflation.
More ominously, the Eurozone is vulnerable to crisis because of the lop-sided nature of its economic governance—a powerful central bank, but a tiny, non-adjustable EU budget, with fiscal spending at member-state level constrained by the SGP.
In this sense, the US is far better equipped to combat recession; its Central Bank is required to treat inflation as only one of three criteria, while Congress has discretionary power to use the federal budget counter-cyclically; eg, it accepted George Bush's reflationary package worth 1% of GDP, however poorly targeted the package may have been. The EU has no such discretion, but instead is bound by rules-driven automatic stabilisers inspired by bankers' notions of 'sound money'.
True, when the downswing really starts to hurt the ECB still retains plenty of scope to cut interest rates. But what happens when monetary policy becomes ineffective. In truth, Brussels will need to reconsider Keynes and the Eurozone's economic architecture will need to alter drastically, or else the very existence of the Eurozone will be in peril. For pro-Europeans like myself, that is the harshest lesson of the present crisis.
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