Demand relief required to uncouple Europe from its misery

Unless policymakers recognise demand side problems, then Europe’s financial misery will continue suggests Valentijn van Nieuwenhuijzen, senior strategist at ING Investment Management.

The crisis just keeps going on and on. True, it has gone through different stages over the past five years, but the move from the US subprime crisis in 2007 to the European debt crisis is more a transformation than an elimination. A major reason for policymakers’ failure to find an effective response to the crisis is their inability to make the correct diagnosis. The current debt problems are posing very different economic challenges than those of the previous decades. Except for the comparable problems which Japan has been struggling with over the past 20 years. It remains striking, therefore, how little has been learned from the persistent Japanese stagnation which followed the boom-bust cycle in property and share prices and the debt crisis it triggered. Unfortunately, the Japanese experience remains largely ignored by the rest of the world. In Europe most politicians and other policymakers tend to come up with ‘1980s’-type solutions to problems of a completely different nature.

An inflexible supply side of the economy due to excessive government interference, overbearing trade union power and rigid wage indexation are primarily problems from the past. During the 1970s and 80s an economic climate developed in which too little production capacity clashed with too much demand for goods and services. This led to wage-price spirals, high inflation rates and overblown public sectors which put a brake on productivity growth. Having digested this knowledge, policymakers are now preaching the old-fashioned mantra of supply-side reforms and a smaller public sector. Measures which proved very effective in tackling the problems of 30-odd years ago, but which have little to offer in the context of the challenges ahead.

That is because virtually the opposite applies these days. The economy now faces a huge shortage of demand given the available production capacity. This problem is a direct consequence of reducing debt piles. While the focus remains on debt reduction in both public and private sectors, demand for goods and services will remain sluggish. As a result, virtually all large developed market economies are still performing well below their potential, and dangers such as wage-price spirals and slowing production capacity expansion are not the main concerns.

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