Where Monetarism Leads

Adrian Pabst writes:

This week European stock markets slumped by up to 6% when the Fitch credit rating agency downgraded Greece's creditworthiness to a 10-year low. With national debt approximating 125% of national output, the country's dramatic fiscal imbalance undermines the stability and unity of the eurozone.

Being part of the euro deprives Greece of the capacity to devalue its currency or to inflate its debt. If Athens deflates and adopts a draconian fiscal contraction, social unrest looms on a far greater scale than this week's street riots on the first anniversary of a police shooting that killed a student. If, on the other hand, Greece were to default on its debts, it might be forced to abandon its membership of the eurozone. The ensuing crisis could engulf Italy and other member countries, threatening to bring down the entire edifice and dealing a massive blow to Europe's global economic credibility.

Unfortunately, the eurozone's dogmatic commitment to monetarism exacerbates the economic predicament of its members. Monetarism stipulates the pursuit of price stability by focusing exclusively on monetary policy instruments such as interest rates to control the money supply. In the case of the euro, the monetarist stance of the European Central Bank (ECB) is reinforced by an exceptionally tight fiscal policy regime with strict, legally binding limits on the level of national budget deficits and public debt.

Taken together, the eurozone's monetary and fiscal policy mix amounts to an economic straightjacket. Since Europe's currency union is based on national fiscal restraint and low inflation rather than high growth, it has an inbuilt contractionary bias which risks interrupting the nascent recovery before it has properly taken off.

As the government acts on Alisdair Darling's pre-budget report, it should think twice before passing a bill with legal obligations to reduce public debt and budget deficit. In the foreseeable future of stagnation or low growth, that could plunge the country back into recession and in a vicious circle of debt-deflation, with potentially disastrous consequences for growth, employment and social cohesion. Like the eurozone, Britain must ditch monetarism – a core tenet of the neoliberal orthodoxy which the current crisis has utterly discredited.

Defenders of monetarism contend that price stability is a precondition for investment, and that after a global credit crunch the only way to generate growth in the real economy is by expanding the money supply. They point to the success of massive liquidity injection through the central bank policy of quantitative easing, implemented by both the ECB and the Bank of England.

The trouble is that central banks across Europe are already planning to withdraw quantitative easing – even before lending to businesses and households has properly resumed. In fact, the continuing crisis highlights the growing disconnect between global finance and the real economy, with banks and financial institutions using taxpayers' money to engage in frenzied short-term speculation rather than supporting productive, income-generating activities through longer term investment. That's why we are seeing a return to a bubble economy of boom and bust, rather than a more stable business cycle.

Crucially, the slow recovery shows that growth depends in large part on aggregate demand (basically total investment and consumption), and not on the money supply. That was John Maynard Keynes's ground-breaking argument after the Depression of 1929-33.

The problem with monetarist limits on fiscal policy is that they lack any genuine economic rationale. They are largely intended to reassure the world economy that global finance won't have to compete with public authorities on international money markets. As such, monetarism locks governments into a fiscal cage in order to promote the free movement of worldwide capital. But in the current situation, with massive output gaps, public spending won't crowd out private investment. Expenditure on shovel-ready infrastructure projects or spending vouchers for low-income groups helps restore confidence and boost the economy through the multiplier effect – demand begets demand.

As the eurozone emerges from the worst European recession for more than 70 years, it must envisage fundamental reform.

First, there must be a revision of the ECB's constitution to include growth as a policy objective on the same level as price stability. Here Europe can learn from the US Federal Reserve's more pragmatic and proactive stance.

Second, there should be a fiscal co-insurance scheme for countries to provide temporary relief to fellow members in the event of a crisis when the economy is shrinking and debt level are soaring. If governments can use taxpayers' money to bail out the banks that got us into the current mess, they should be allowed to come to the rescue of other countries in dire straits.

Third, by increasing the funds and the remit of the European Investment Bank, the EU as a whole can foster a new economic culture of long-term investment in infrastructure, research and research and development which is the surest way of generating sustained growth and reducing fiscal imbalances.

Instead of fuelling the deficit-cum-debt hysteria, responsible politicians and policymakers must eschew monetarism in favour of a proper high-investment, high-growth strategy. The future of the eurozone – and of the UK economy – depends on it.