In the Wake of Brexit, Will the EU Finally Turn Away from Austerity?

 Photo Credit: The Happy Rower via Compfight CC-BY-NC-ND.
Photo Credit: The Happy Rower via Compfight CC-BY-NC-ND.

Voters in the United Kingdom caught almost everyone by surprise with their decision to leave the European Union. The push for Brexit was driven by nationalistic, xenophobic and racist sentiments. There is no point in putting a pretty face on it. But this vote is now a fait accompli. The question is how the leadership of the European Union chooses to respond.

In the lead up to the Brexit vote, there was much discussion of punishment. Wolfgang Schauble, the finance minister of the European Union, had made several comments implying that the UK would be punished if its people voted to leave the European Union. The idea was that if they don’t want to be in the European Union, then Schauble and his colleagues would impose substantial trade barriers following the country’s departure. Since the UK is so heavily dependent on trade with the EU, large trade barriers would impose real costs on the British economy.

Of course, such trade barriers would also impose costs on the EU. The costs would not be as large on the block as a whole since the UK is less important to the EU than vice-versa, but the costs would nonetheless be a big hit for the countries that have the most trade with the UK. In effect, the EU leadership would be imposing costs on its people in order to punish voters in the UK for wanting to leave.

Some of the drive for punishment seems like a spurned lover story. Having been rejected by UK voters, the EU leadership is now intent on making them suffer. That’s not the sort of attitude that should determine economic policy.

But there is a more serious angle. The UK is hardly the only country where much of the public is unhappy with the EU. If the UK can engineer a relatively painless departure, then other countries may wish to follow its lead. From this vantage point, punishment is important since it will show the rest of Europe that leaving the EU really hurts.

It would be unfortunate if the EU went this direction. The better path would be to ask why it is that so many people are unhappy with the EU. It isn’t too hard to find answers. Part of this is the bureaucracy, which is widely viewed as bloated and unresponsive to the European people. However, what is probably more pressing for most voters is the state of Europe’s economy.

Many countries in the EU still have not recovered their pre-recession level of output and employment. For example, GDP is still down from its 2007 level by almost 6.0 percent in Portugal and 8.0 percent in Italy. Employment in Spain is down by more than 2 million, which is more than 10 percent of its pre-recession employment. In Greece, employment and GDP are both down by more than 20 percent, a track record that makes the Great Depression look mild by comparison.

This bleak economic performance was not dictated by the gods. It was the result of the conscious decision by the EU leadership to turn toward austerity in 2010, long before the economy was close to having recovered. Rather than using fiscal policy to steer economies toward full employment and address needs in infrastructure, clean energy, education and health care, the EU leadership demanded that governments move toward balanced budgets. This meant cutbacks in spending and tax increases that worsened and prolonged the downturn.

The EU leadership apparently likes balanced budgets. It may be something their parents told them. But the EU and the world can no longer be governed by folk wisdom handed down from prior generations; it needs to use real economics. And in real economics, the message is clear, they need to run larger budget deficits to boost economies and reduce unemployment.

The logic here is straightforward. If a deficit is too large it pushes up interest rates. And if central banks accommodate large deficits to keep interest rates down, then it leads to inflation.

Well, interest rates are about as low as they can be. In fact, the interest rate on Germany’s 10-year bond is now negative. You have to pay the German government to lend it money. Inflation is also nowhere in sight. The inflation rate has been barely positive for most of the last five years and certainly well below the European Central Bank’s 2.0 percent target. It’s hard to see a serious harm if interest rates rose to more normal level and inflation increased to the level that the European Central Bank targets.

In short, there is no argument against spending more money to both boost growth to create jobs and meet real needs.

The proper response to the Brexit vote would be for the EU leadership to finally embrace reality and adopt an economic policy that will push the continent toward stronger growth and full employment. If it goes this path, the rest of the EU will not be anxious to follow the UK’s lead.

If the EU leadership instead goes the route of tit for tat and tries to punish Britain, Brexit will be the first round of a very unhappy story.

Source: CEPR