Let’s start with a few claims that (most) people agree with:
2. The U.S. has higher income inequality than most of Europe and our high earners have done quite well for some time.
3. Many events happen in the U.S. first.
4. The U.S. is more flexible than most European economies, though not obviously more flexible than say Germany or Sweden.
OK, let’s tie those pieces together, but please keep in mind that I consider the following to be speculative.
IT and China, taken together, seem to imply a big whack to median income. This whack should be higher for the less flexible polities, and furthermore the wealthy and the well-educated in the U.S. get back a big chunk of that money through tech innovation and IP rights. Plus we’ve had some good luck with fossil fuels and even the composition of our agriculture. If you had a country without those high earners in the tech sector, and an inflexible labor market, those economies will have to contract and I don’t just mean in a short-term cycle. Equilibrium implies negative growth for those economies, at least for a while.
By how much? If the relatively flexible U.S. lost 8% of median income, perhaps Italy and Spain and Greece have to lose 15%, but with no offsetting major gains on the upper end of the income distribution. (How flexible is Ireland or for that matter France is an interesting question and so far the answer is not obvious.)
In sum, the less flexible European economies will lose at least 15% of their gdps, due to trade and technology.
There is then the question of what the path downwards will look like and feel like. Being in the eurozone makes adjustment much harder, and brings the doom more quickly, for reasons which are by now well-discussed.
The initial path looks like this. The real sectors of those economies start to appear weaker, and this sets off some deposit flight and also a credit contraction. AD and AS fall together and set off some further negative interactions. In the case of Greece the expectation of the country being “a European economy” gets replaced with the expectation of the country being “a Balkan economy,” to the detriment of investment of course. Along the way, the true nature of the EU political equilibrium is revealed, expectations of EU cooperation decline, and that sets off further AD and AS downward spirals.
Trying “austerity” will hasten the fall, but at the same time it is hard to see how an economy contracting by 15% could in the longer run keep its previous level of government spending, or for that matter find a “good” time to do fiscal consolidation. It will appear that “austerity” is more causally important than it really is.
All sorts of particular stories will get told along the way, including the austerity story. Those stories may look true, but ultimately they are more about timing and trajectory than about fundamental causes. What I call “time compression” will very often appear to be causality.
A lot of the problems caused by fiscal consolidation are in fact “sectoral shift” problems. For instance cuts in government spending lay off workers and the Mediterranean private sector — in the midst of a significant contraction and somewhat inflexible to begin with — is unlikely to rehire those workers. The fiscal policy advocates actually have an argument against their “let monetary policy do all the work” critics, although their obsession with AD prevents them from emphasizing the sectoral shift aspects of the fiscal story, which are in fact the paramount aspects.
How much has the Greek economy contracted already? (Hard to say with black markets and bad numbers but I think at least 20%). It is predicted that the Cyprus economy will collapse by 20% over the next three years. Think of their banking sector as unsustainable in the first place, but its decline being hastened rather suddenly by the curious structure of the euro and bank runs (again, time compression). It is not crazy to expect a ten percent permanent contraction for Italy and a very slow recovery for Spain after what is already a major contraction.
By the way, UK employment is now at an all-time high, as jobs have been reshuffled to lower-value service sector activities, and out of oil and finance. Does that fit the Keynesian story? Sorry people, but I have to say “no way.” Maybe the UK economy — which is flexible but not well-geared to export and to compete internationally — is on a path to lose five or ten percent of its gdp, with or without “austerity.”
Empirically, how would one distinguish this story from a more traditional Keynesian account?
1. Both imply that “austerity” appears causally correlated with bad outcomes. (By the way, ngdp targeting is still the way to go, although the lack of such a policy is a secondary or residual problem rather than the primary problem.)
2. Given the massively high unemployment we have seen, the Keynesian account would lead us to expect corresponding rates of price deflation comparable to those of the Great Depression, such as negative ten percent. We’re seeing rates of inflation between zero and two percent, with prices often continuing to move up. Inertia in sticky wages won’t get prices moving up like that, not if AD is supposedly collapsing to an extreme degree and as a driving force. This is pretty close to a “one fact” refutation of the simple Keynesian account. Study economic history all you want, 0-2% inflation may be suboptimal but the associated AD implications simply aren’t that bad, nor will adjusting for a few VAT hikes make it so. What we get is a series of blog posts measuring AD collapse by invoking surrealistic standards, and obscure concepts from modal logic, and failing to notice that price level behavior simply does not fit the story.
3. The Keynesian account implies a fairly quick bounce back for the plagued countries which (eventually) reject “austerity” and goose up AD. The theory here implies a quick bounce back for flexible economies, economies with IP and resources, but no rapid bounce back for the euro periphery, no matter what their policies, at least short of an extremely radical and probably impossible set of structural reforms, such as making Italy into Sweden. In any case, this test has not yet been run as those countries are still on the downswing.
In this account, AD economics, including its Keynesian and neo-monetarist forms, is correct, but it is also far from the entire story.