We still need, very much, that factory floor

JP-pic 2Dr. John Psarouthakis, Executive Editor of www.BusinessThinker.com, Distinguished Visiting Fellow at the Institute of Advanced Studies in the Humanities, University of Edinburgh, Scotland, publisher of www.GavdosPress.com and Founder and former CEO, JP Industries, Inc., a Fortune 500 industrial corporation

After I launched JP Industries in the 1980s and was growing it into a major auto components firm, new acquaintances usually asked me how big the company was.  If I told them it was a half-a-billion-dollar company, they were likely to say:  “No, I mean how many people do you employ?”  That question no longer defines a company, and no one asks it anymore.  For sure no one asks that question about General Motors, except in wonderment at how America has changed since the 1950s. But neither does anyone use workforce size to define new non-manufacturing icons such as Amazon or Facebook.  Sales and profits determine the size of a company today.  Some politicians and pundits have a quick, cynical, simplistic explanation for that new dynamic: corporate greed.  They are wrong—wrong enough and populist enough to lead the gullible over the cliff we discussed earlier.

The nation’s formerly largest corporation, for example, did not have a history of pushing workers out the door to maximize profits.  The overly generous remuneration of the General Motors workforce, on the job and in retirement, was in fact one major cause of GM’s financial catastrophe.  Big government and big manufacturing both spent the last half of the 20th Century laying land mines beneath their own feet.  How can one quarrel with that description of entities that wind up with retiree costs dwarfing current payrolls?  It is complicated.  Demographics of an aging population, efficiencies that require fewer and fewer employees to accomplish the same work, global competition driving down profit margins, that same competition leading to better products that last longer . . . it is an intricate picture.  But unless one’s mind is mired in a utopian, socialist fantasy, the bottom line is quite simple:  compete or die.  You can’t make a bad product and sell it into a market of good products.  And you can’t sell a good product that costs twice as much as someone else’s equally good product.  This dynamic—a few outlier examples excepted, as in every endeavor under the sun—is not about greed.  It is about centuries-old market truths, which are becoming even truer.

An eerie parallel to the GM saga can be found at the bottom of the government and taxation food chain, where numerous municipalities around the country have been lining up to declare bankruptcy or de facto bankruptcy.  The only competition in the local government arena is with state and federal governments for tax dollars.  At this most labor-intensive level of government, however, “legacy issues” are the same in a bankrupt city as in the old smokestack industries.  Overly generous retirement and health-care benefits, padded payrolls, and slipshod fiscal management have left some cities struggling to pay retired workers even while current workers—including police officers—are being laid off.  As a footnote to that fact, here—and in numerous other paragraphs of this book—I could easily add an exclamation point that asks: “Why did a thousand headlines proclaim that ‘America Is Not Greece’?”  Are you kidding?  Show me a bankrupt American city and I will show you Greece without the Mediterranean.

In 1914, only 17 years before Brave New World was published, Henry Ford’s assembly line workers were rejecting oppressive, mind-numbing production work in astounding numbers.  Ford needed to hire and train more than three men if he wanted to find one who remained on the job at year’s end.  To solve this costly and counter-productive problem, Ford stunned the world by doubling workers’ wages to five dollars.  Ford’s new pay scale famously increased number of consumers able to afford a car, but this was a mere footnote to his strategy.  Ford’s motive was to solve a productivity problem while keeping his product competitive.  From a worker’s vantage point it was all about a 100 percent pay increase (plus the bonus of an eight-hour workday instead of nine).  From a business vantage point it was all about productivity (the eight-hour day meant Ford could operate three shifts a day, instead of two), getting those Model T’s out onto Woodward Avenue, not wasting time spent hiring and training workers, and solving an acute labor shortage.

The automakers applied that template far past its rightful expiration date, into an era when labor costs were allowed to exceed common sense and management muffed a latter 20th Century challenge from foreign manufacturers.  Almost 100 years passed from the $5 day until competition and technological realities and failure to live within their means brought the automotive American Three (formerly the Big Three) to their knees.  In the real world, the sun rises and sets, death and taxes are certainties, and any business that doesn’t compete will sooner or later—usually sooner—go bust.

During the manufacturing segment’s American Century zenith, the platitude said that when Detroit sneezes, America catches a cold.  That assertion might have been overused, but it was entirely true.  Detroit was America’s largest employer.  Its indirect economic impact defied calculation.  The steel industry, parts manufacturers, electronics and glass companies, road builders, garage mechanics, salesmen—even a huge part of the advertising and newspaper and broadcasting businesses—stayed healthy only if Detroit stayed healthy.   That was not just a sneeze you heard at the dawn of the 21st Century.  The bigger they are, the harder they fall.

Detroit’s car companies, made vulnerable by complacency and after staggering for several decades, nearly went down for the count.  Those humiliating few weeks on the brink might be the place to mark the true beginning of the 21st Century.  Historians could find few bookends more aptly symbolic than the $5 Day on one end and The Bailout on the other.  All four 21st Century Benchmarks factored into the nearest bookend—global competition, technological advances (the first widespread, heavy-duty, real-world use of the word “robot” occurred in the car industry), the need for education reform (no Henry Ford waits at today’s factory door to hire and train, at double pay, workers straight off the farm or straight off the boat), and a synergistic need for new thinking in our manufacturing segment (for direct job creation, of course; but equally important as a nearby laboratory to continue our status as an exporter of innovation).  It all added up to that very 21st Century matter of Vector One companies becoming a source of unemployment rather than a source of new jobs.

Perhaps no image so perfectly signaled the futility of resistance to the coming new century as did those photos of angry American autoworkers taking sledgehammers to Japanese-made cars, even as the Japanese were moving to build cars in America (competitive cost and productivity realities, you know).  The days of bludgeoned Toyotas are past, but more sophisticated (and more dangerous) resistance to the new era remains.  We need to do more than merely accept that the calendar has turned; in a single grasp, we need to confront the new century and embrace it.

One can forgive the politicians and the pundits and the unemployed themselves for chanting “Jobs, jobs, jobs!”  That is after all a noble and very American chant, quite different than “Handouts, handouts, handouts!”  The trick will be to move the dialogue (and the chants) away from instant (and obsolete) jobs, while avoiding surrender to the handout mentality.  Instead, we need to chant for a new job-creating environment and a new paradigm for producing qualified job candidates.  There was a time when it might have been valid in a recession to expect jobs could materialize from a tweaked tax rate here, a money-supply adjustment there, or—mostly, like a fresh breeze inevitably closes out a heat wave—an “uptick in the business cycle.”  That always happened sooner or later after Detroit caught a cold.  Today’s challenge is not cyclical.  It is fundamental and technological.  No one would have accomplished much by standing in a 1912 cornfield chanting: “Farm jobs, farm jobs, farm jobs!”

The farm-to-factory social and technological upheaval, though massive, was a small reflection of where we stand today.  No one has constructed an oven the size of Kansas in which to bake a much, much larger Mom’s apple pie.  If we are smart, we’ll make manufacturing the core—and “core” is precisely the right, if surprising, word—of how we meet and mold the future.  We can make the American manufacturing sector our prime route toward “Jobs, jobs, jobs!” once again . . . not as directly as in the past, not in any 20th Century way, but nonetheless as a vital driver of prosperity for all.  Millions of lunch buckets won’t be carried into the factories of the future.  The livelihood of most Americans, however, will depend on the health of American manufacturing.

As we talk about bringing our manufacturing sector into a new era, we need to keep a couple things in mind about this powerhouse that drove the American Century.  More than 70 years have passed since FDR, a year before Pearl Harbor, dubbed our mills and factories “The Arsenal of Democracy.”  It has been a long time since you heard commonly expressed awe about our “industrial might.”  The numbers, however, remain mighty.

First, the service sector (and especially computer-related technology) has radiated all the workplace sex appeal for a generation or two, but guess what?  We remain the world’s largest manufacturer.  In 2011 we produced a fifth of the entire world’s manufacturing output.  If one must pick oneself up after being knocked down, that is the best possible floor to start from.

Second, it is true that manufacturing accounted for 31 percent of U.S. non-farm employment in 1950 and that 60 years later that percentage had dipped below 10 percent, but guess what?  Almost 12 million Americans work in today’s manufacturing sector, a number that posted modest gains in 2010 and again in 2011—the first years that had seen an increase since 1997.

Third, 12 million jobs is a lot of jobs, no matter what percentage they might be of our total workforce.  Despite its troubles, U.S. manufacturing obviously has not been driven into antique status by an inability to compete.  It is nowhere near extinction.  It has so many assets, in physical plant and productivity and business culture, that if we did everything wrong and stayed on the road to government-centric and dwindling world importance, we would still be making things.  Not enough things.  Not the right things.  Our people would suffer from all that dwindling.  But we would remain on the list of manufacturing countries.  Take just one-half of our current manufacturing might and set it down in any other leading developed country and you would be looking at the new global superpower.

In other words, American manufacturing has big challenges today, and faces bigger challenges tomorrow, but is nowhere near being a disaster zone.  Viewed as a single unit in a mind exercise, one could analyze the U.S. manufacturing sector as an underperforming company—one with an upside and a downside the likes of which have never been seen in world history.

The downside would be to allow a vibrant, highly productive, innovative conglomerate atrophy quickly into mediocrity with dangerous consequences for all Americans.  The upside would be to refocus the world’s largest, most important “company” in midstride, nip its foreseeable problems in the bud, retool (as all manufacturers do), and soar to new heights as the winner and still champion of a larger, well . . . global pie.  The bad news is that American manufacturing has reached a decisive crossroads.  The good news is that the proper path to choose is obvious.  The further bad news is that American society (meaning all levels of government and the will of the people) must commit to the live-or-die effort (see “infrastructure,” see “education”).  The further good news is this manufacturing rebirth can be achieved, if we somehow summon that shared resolve—which seems to be the key to success when one looks at these 21st Century survival issues from any direction.

No one could estimate with acceptable accuracy how many Americans would be willing (or fiscally able) to report to work at the wage rates foreign suppliers pay offshore workers to produce countless low-value products.  My best guess is almost none would sign up.  Americans already turn their back on jobs paying wages that, although low by our standards, are much higher than millions of manufacturing jobs around the world.  If someone in Asia produces wood screws that could be made here by workers earning half the U.S. minimum wage—is that a question worth asking?  Should we even bother bemoaning the loss of such jobs?  Of course not.

Nor could anyone could estimate with acceptable accuracy the number of American manufacturing jobs that have been lost as a direct result of companies moving overseas, or as a direct result of imported goods taking market share from domestic product, or as a direct result of domestic regulatory and taxation issues, or as a direct result of new efficiencies.  Technological advances would have eliminated a certain number of jobs from the factory floor even if no factory existed anywhere in the world except the lower 48 states.  That fact is among the reasons it’s impossible to sort out reasons jobs are exported, let alone to add up accurate numbers.

Let’s imagine a hypothetical small-town Midwest plant where 2,000 employees manufacture dishwashers.  Let’s say that one sad morning the entire operation disappears to Mexico, where workers are paid a small fraction of Midwestern wages.  The reason for the exodus appears cut-and-dried: pay rates.  But there are also regulatory issues, including some that do not involve worker safety or sensible stewardship of natural resources.  There are tax issues (the dishwasher company has been marginally profitable, at best, for 15 years, but in each of those years it has paid 30 percent of the town’s school system budget, bought all its police cars, and paid a far larger share of water and sewage costs than pro rata accounting would demand).  The plant’s union has accepted a pay freeze in several contract negotiations—but refuses to budge on antiquated work rules (antiquated, of course, by new technology), and actively nurtures workforce resentment against management.  While the plant’s profitability slouched toward ancient history, two of its major suppliers outsourced key parts to . . . Mexico.  For these and other reasons—bottom line being compete or die—there is no way this plant could stay in the Midwestern town where it had been an icon for many, many years.

Keeping in mind that technological advances are irreversible, and that a light breeze of new technology can produce gale-force change in a given market, “tech” clearly is shorthand for both the problems and the solutions we are discussing.  Technology’s long-term impact upon the job market, in fact, dwarfs all the headline-grabbing events that first created a new meaning for an adjective (offshore), then a brand-new verb: “to offshore, as in ‘Ajax offshored its parts department.”

Technological advances even played a major role in the loss of our mythical dishwasher factory to Mexico, though that might not be apparent.  Communications technology and transportation technology, for example, today allow a product to be assembled and shipped in containers from the farthest village on the planet.  A warehouse supervisor in Brooklyn (or anywhere else) can tell you in an instant the exact location of a particular unit still in its crate—the kind of tracking that not many years ago would have required time and effort even if that particular dishwasher were sitting in the warehouse 30 yards from the supervisor’s desk.  Inventory management, the parts pipeline, quality control—a very long list of chores have been simplified and improved by technology that already has begun to seem old, and which makes off-shoring a competitive solution in situations where it used to be impossible.

Meanwhile, dishwashers—and numerous other home appliances—arrived on the consumer scene to acclaim befitting futuristic technological marvels.  But one by one, as their technology became commonplace (as did their mass manufacture), these appliances morphed into mere manufactured commodities.  That is, unless they are built by a truly inept company, all models in the same price range are essentially the same in construction and quality no matter who builds them.  I would argue—and have so argued—that even today’s automobile, the mass-marketed models at least, have become manufactured commodities.  If one buys any major carmaker’s best-selling mid-sized sedan with similar amenities, one can expect to get a good product that will run well, last a long time—and carry the same number of people, at the same speed, in the same comfort, with approximately the same gas mileage and safety as any other best-selling mid-sized sedan.  You will of course quarrel with that assertion and defend your favorite brand, for various idiosyncratic reasons.  In some subjective ways you may be right . . . just a little bit.  But a well-constructed car of a particular class is a well-constructed car of a particular class.  Much like, say, dishwashers of a particular size and class.

Any of these durable goods products is infinitely more sophisticated and differentiated than a generic bushel of wheat or a silver ingot, for sure.  A side by side refrigerator is a manufactured commodity, not a raw product.  But the days when Frigidaire was synonymous with refrigerator (or Kodak synonymous with camera) are long gone.  The things that most endear a particular automotive nameplate to buyers these days are cost and service—two things that cannot be manufactured into a product.  The cost factor is decided in the engineering and design departments before manufacture begins.  Superlative service is something the customer receives after the product has been designed, manufactured, shipped, and sold.  Absolutely nothing about these two crucial factors has a thing to do with whether the product is made in Illinois or the other side of the world.

So it’s a wide range of manufacturing that has been, or threatens to be, shoved offshore by competitive forces.  Some products—many products—offer no reason whatsoever for trying to keep their manufacture in the U.S.  No one here wants to work making, say, Polynesian cocktail umbrellas at 25 cents an hour.  We lose no technological edge by letting someone else, somewhere else, do that work.  Goodbye, Mai Tai swizzle stick manufacturing sector.  Gone for good.  That’s easy (and intentionally simplistic).  But what about those dishwashing machines?  What about, say, the American furniture and textile industries, which have seen historic local economic bases pack up and leave northern locales, relocate in the southern U.S., then move yet again, this time offshore?  We’ll leave parts of those valid questions to be answered in later discussion of globalization.  Here, let’s stipulate three things—irreversible change is irreversible, free markets are not merely a good thing but the only way to grow that economic pie, and “compete or die” is an absolute.  If we honestly acknowledge those three things (and we have no other choice), then any forward-looking discussion about 21st Century manufacturing—painful as it may be for workers who made those dishwashers and textiles and furniture—is not at all difficult to outline.

First, the profit centers in manufacturing (and therefore the best and best-paying jobs) involve deploying the latest technology to produce value-added goods.  You can use dayglow paint and the best wood available in the Far East, but you simply are never going to add any value to those cocktail umbrellas.  They are what they are, toothpicks and paper, a very bottom-tier commodity.  Building a contemporary mid-sized automobile, on the other hand, is not a matter of dropping an engine on a chassis and adding some fenders, which more or less is what happened on the Model T’s horseless carriage assembly line.  Today’s car is a manufactured commodity, but it also is a mobile technology center of magnificent scope—loaded with on-board computers and high-precision mechanical components, engineered for safety and reliability that would stun those who designed any of America’s classic cars.  Making cars is one kind of manufacturing we want to keep in the United States.  Fundamental to understanding 21st Century manufacturing, however, remember that it takes fewer workers to assemble one of these modern marvels than it took to assemble a Model T.  No doubt it will take even fewer workers in the future than it does now—as I discussed in that old Grand Rapids speech.

Second, any manufacturing that uses high levels of new technology is the kind of manufacturing we want to keep on these shores.  That’s true even if its labor force is small, even if its direct contribution to GDP is so tiny as to not show up on economic radar.  Why do we care about such a company?  A tiny, technology-intensive company surely means nothing to the economy in the way a car manufacturer’s payroll does.  Absolutely true; a GM job roster is a precious thing to be treasured, even if it is but a shadow of its old self and even as it shrinks because of new efficiencies.  But it isn’t workforce size that makes the car companies—plus any companies that demand new technology but amount to mere blips in the economy, plus all other technology-consuming companies of any intermediary size—the core of our 21st Century economic paradigm.  Almost all these companies, just like 19th or 20th Century companies, will continue to demand varying degrees of raw materials and finished parts, require vendors of every type, and hire their share of accountants and sales reps, and plant maintenance people—every job description imaginable.  What makes these companies uniquely vital to the 21st Century, though, is not their direct labor forces, but all that technology consumption.  That’s because . . .

Third, technology—rather than the durable goods our manufacturers produce—could fairly be viewed our most important product in the 21st Century.  It’s a close-knit synergy.  For example:

 

  • Technology, as noted, fuels the most prosperous manufacturing industries, which are excellent creators of new wealth, the lifeblood of any vibrant, growing, free-market economy.

 

  • It logically follows—and experience usually supports the logic—that high-tech manufacturing wants its best sources of new technology to be located nearby.  A sophisticated manufacturing facility that winds up thousands of miles from its laboratory will, if possible, tend to move the lab near its manufacturing facilities.  Similarly, an industry that has its labs and all the best related outside intellectual support based in the United States has, obviously, a good reason to “stay home.”

 

  • New technology derives from both private and public research, sometimes jointly and sometimes singly, but in either case demanding a world-class university system.

 

  • The United States currently boasts the foremost graduate schools on the planet, as evidenced by the world sending so many of its best and brightest here for an American education.  One could compile a long manifest of reasons we should sustain this technological/educational leadership.  For reasons apparent within this book’s context, we must maintain that leadership.

 

  • The concept of technology as a “product” is not really a figurative thing.  Technology is intellectual property.  It makes things work.  Once a product’s ingredients advance beyond raw materials and sweat and toil, it is technology that adds value to that product.  The right technology in the right application is a profitable thing.  Companies buy and sell technology every day.  Occasionally a nefarious company (more often a nation) will steal technology, or will produce a quasi-legal clone of a technological process.  Technology is real, as solid as the chair you are sitting in.

 

  • A new piece of technology—in its pure conceptual form, or as a plan for application in manufacturing, or as a completed high-tech manufactured product . . . or in the nascent form of a new Ph.D.’s brainpower—will be our greatest 21st Century export.  Again, it must be thus, or this is most definitely not going to be a great century for the U.S.

 

That is the “smart manufacturing” component of our four Benchmarks.  We must manufacture value-added products that consume new technology.  To do that we must create the new technology our manufacturing sector needs.  Then we need to train, endlessly, a manufacturing workforce that can get the job done.  And along the way we need to make smart choices about plugging this new “manufacturing might” into global markets.  It’s a spectacular synergy.  But I think you can see why even though it’s “all about technology,” it’s also all about a new 21st Century manufacturing sector.

“Jobs, jobs, jobs!”?  Yes indeed.  But not in any 20th Century form.  Before too long, in fact, millions of jobs will exist that none of us today can describe, anymore than Columbus could describe, accurately, where his little ships were headed.  That same unpredictability could be said of entire as-yet unborn industries.  Who can predict the precise layout of a high-tech manufacturing matrix derived from new technology several generations into our future, when we don’t yet have a handle on new technology’s impact this afternoon?  This is not a time for planning instant obsolescence with short-sighted, laborious, bureaucratic, faux precision.  The proper path is obvious, but is not marked by GPS coordinates.  It is indeed, as those old guys said on the shop floor decades ago, “all about the United States continuing to make things.”  Our universities and those free-market manufacturers who perform best can get us to our destination, but only if the politicians—and a lack of public will—don’t mess things up.

See also the Book “The Technology Imperative: What Jobs! Jobs! Jobs! Really Means in the 21st Century”, Gavdos Press, 2012. (www.gavdospress.com)

 

 

Europe’s big sleep

nikos_konstandarasNikos Konstandaras is managing editor and a columnist of Kathimerini, the leading Greek morning daily. He is also a contributor to The BusinessThinker.com

Something strange is happening in Europe. Member states are drifting toward elections for the European Parliament, as fears grow that the election of many members of nationalistic and euroskeptic parties will hinder further union, yet no one is rushing to fix things. The major countries, those which usually take the lead, are not leading. Smaller ones are absorbed by their problems. And the challenges in the broader region and in relations with the United States are growing. It is as if the dream of collective security and prosperity has been abandoned and each country is pushing through the forest on its own.

Germany, the greatest European power because of its economy, is playing for time. For many months before the September federal elections, Europe waited. Six weeks later, we are still waiting for a government to be formed and have seen no initiative aimed at dealing with the economic crisis and its explosive social and political consequences. Indicative of this is how Chancellor Angela Merkel recently referred Prime Minister Antonis Samaras to the troika of our creditors when he tried to discuss changes to Greece’s economic restructuring program – as if the political management of the crisis is a technical matter.

Germany is in no rush, because it is not one of the country’s facing a debt and deficit crisis. On the contrary, its economy is coming out stronger. But as long as Berlin does not push initiatives, the more social and political tensions will rise and bring greater numbers of euroskeptics to the European Parliament. This will affect many countries’ domestic politics, but with the European Parliament undertaking ever more important functions, it will also hobble Europe’s future. Italian PM Enrico Letta, whose country (like Greece) faces a large public debt, high unemployment and popular discontent, recently expressed the fear that if mainstream pro-EU parties got less than 70 percent of the seats, we would face a “nightmarish legislature” in Strasbourg.

Germany is absent, but France is chasing its tail, afraid to tackle the reality that it can no longer afford the social democratic benefits that its people are used to. The government also has to deal with the challenge of the extreme-right National Front. In Greece, the Netherlands, Finland and other countries there is a strong extreme-right current.

Britain, meanwhile, is trapped by the domestic discussion on a possible referendum (by 2017) on the country’s future in the EU. There, too, a euroskeptic party, the UKIP, is on the rise, while there is a strong anti-Brussels wing in the ruling Conservative Party.

Time is passing and the EU countries seem oblivious to the danger that social insecurity and unemployment are strengthening the forces that oppose the idea of a united Europe. Like sleepwalkers, they are headed for a collision with reality.

Austerity and stupidity

bini smaghi

Lorenzo Bini Smaghi is a former member of the ECB’s Executive Board (2005-2011). He is currently visiting Scholar at Harvard’s Weatherhead Center for International Affairs and at the Istituto Affari Internazionali in Rome.

This article is posted here in accordance with the policy of VoxEU.org

Today’s austerity, many argue, is stupid. This column argues that today’s EZ austerity may arise from stupidity before the crisis – specifically lacklustre structural reform. Excess debt arose in nations maintaining unsustainable living standards and welfare systems in the face of poor growth. The Crisis forced radical adjustments such as austerity in a recession. It’s not austerity which caused low growth, but low pre-Crisis growth which ultimately caused austerity. The way out of austerity is fundamental pro-growth reforms that create room for more gradual fiscal adjustment.

The recent Eurozone crisis has shown that austerity measures are self-defeating. They produce severe recessionary consequences which – at least in the short term – tend to increase public debt, as a ratio to GDP. This assessment is confirmed by econometric analysis showing that budgetary adjustments have been more recessionary than expected, with fiscal multipliers being higher than unity (Blanchard and Leigh 2013).

The overly restrictive nature of austerity can be clearly illustrated in Figure 1, which replicates a chart produced by Paul Krugman in a recent New York Times Op-ed (Krugman 2013). The negative correlation between austerity measures implemented by Eurozone countries in the period 2008-2012, as measured by the IMF, and the growth rate over the same period appears to be quite strong – the magnitude of the coefficient exceeds one. The conclusion from these findings is that austerity is not the best way to cure public finances.

Figure 1 Austerity and growth

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Why the mistake persists

The question should then be asked: Why do policy-makers in the Eurozone persist in making the same mistake? The answer implicitly given by Krugman is that policy makers are not particularly smart – or they have been badly advised. Or they have underestimated the effects of their policies. Another way to put it is that by pursuing austerity European politicians are economically ignorant – or stupid.

Assuming that politicians are irrational or stupid may be an easy way out, especially for academics. An alternative way to look at the issue is to question the causality in the correlation between austerity and growth. Krugman considers that by pursuing austerity measures European policy makers show their irrationality, or stupidity. They are stupid because they pursue austerity rather than a more preferable policy option.

Could it be the other way around?

The question that I would like to raise is the following: Could it be the other way around?

European policy makers are not stupid because they pursue austerity, but they pursue austerity because they are stupid, or – to put it more diplomatically – they are short sighted and have ignored other alternatives and were ultimately left with only one option, austerity. In other words, they implemented austerity because they arrived at a point where they had no alternative.

I would like to use the same methodology used by Krugman to explain the point. I would nevertheless like to warn readers as to its limitations. A sample made of only 11 observations should be used with great caution. The results are likely to be biased, especially in the presence of outliers. What follows should thus be interpreted as an invitation for further more sophisticated work.

Looking closely at Krugman’s chart, it is striking how the correlation depends on Greece. Greece is in fact a very specific case. An extreme dose of austerity was applied to an economy characterized by strong rigidities and inefficiencies. Some robustness test should be conducted on Krugman’s analysis.

  • When Greece is excluded from the sample, as in Figure 2, the correlation is still negative, but its magnitude falls dramatically.

Figure 2 Austerity and growth (excluding Greece)

pic2

What else is going on?

The results suggest that EZ economic growth has been influenced by other factors, aside from austerity. The next step is to look at other possible variables which may explain growth differentials across Eurozone countries.

The ideal methodology would be to use cross-section equations with multiple explanatory variables, but the small size of the sample does not allow this. We thus have to proceed variable by variable. Even if the robustness of the analysis is limited, it provides some interesting food for thought.

A first avenue is to look at financing conditions. Eurozone countries with higher levels of interest rates should be expected to have experienced lower growth, because of the stricter financing conditions for the economy as a whole.

  • Figure 3 plots growth and financing conditions, measured by interest rate spreads on long term government bonds and shows that the correlation is relatively strong.

It suggests that countries with higher credit risk have suffered from more restrictive conditions, which have led to lower growth.

This result should of course be taken with caution. The correlation hides the fact that since 2008 countries with higher debt have had to implement higher austerity measures. However, the significance of the correlation, compared to the previous one, suggests that the stringency of financing conditions has played a significant role, aside from austerity, in explaining economic performance. In other words, independently of the austerity measures that they implemented, countries with higher credit risk on their debt suffered most.

Figure 3 Financial conditions and growth

pic3

The analysis can be extended by considering the correlation between sovereign risk and banking risk. This explains the relative tightening of credit conditions in peripheral countries.

  • Figure 4 shows the correlation between growth and credit conditions, reflected by spreads on lending rates charged by banks; the correlation is quite strong.

It suggests that firms’ financing conditions have been an important factor in explaining cross country growth differentials in the Eurozone.

EZ countries which had increasing difficulties in financing their public debt during the crisis suffered from both a credit crunch – as reflected by more expensive bank credit – and the impact of the fiscal adjustment. In other words they experienced both restrictive monetary and fiscal policies.

Figure 4 Credit conditions and growth

pic4

A further step in the analysis is to look beyond economic policies and consider more fundamental structural issues. A starting point is to consider the imbalances which accumulated during the first years of monetary union, expressed in terms of competitiveness and growth potential.

Figure 5 looks at changes in competitiveness, measured by relative unit labour costs, accumulated from the start of the euro until the year preceding the crisis.

  • The chart shows that the countries which lost competitiveness prior to the crisis experienced the lowest growth after the crisis.

In other words, the growth differentials after the crisis are largely the result of the adjustment to the imbalances accumulated before the crisis.

Figure 5 Competitiveness and growth

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The correlation between competitiveness and growth appears to be particularly strong also when considering more fundamental factors, like those included in the ranking used by the World Economic Forum to classify the attractiveness of countries for investors.

Figure 6 Competitiveness (WEF) and growth

pic6

 

  • Figure 6 suggests that the growth rate after the crisis is largely affected by fundamental competitiveness divergences which built up before the crisis.

Countries which are at the low end of the competitiveness ranking are also those that have grown less after the crisis.

This is confirmed by looking at more specific indicators of long term growth potential, which is an important determinant of competitiveness. One can select as indicators of potential growth, as an illustration, internet access and numerical literacy, as measured in the OECD’s recent Skills outlook report, published in October 2013. Figures 7 and 8 show the strong correlation between Eurozone countries growth since the start of the crisis and these structural variables.

  • Figure 6 and 7 results signal that the intra Eurozone performance over recent years cannot be explained only by macroeconomic policies but by more fundamental factors, that relate to growth potential.

Figure 7 Internet access and growth

pic7

Figure 8 Numerical proficiency and growth

pic8  Caution needed

One should be careful in drawing conclusions from these correlations. The sample sizes are small and there is a high degree of correlation among the explanatory variables.

Nevertheless the exercise can be used to raise some interesting and provocative questions. For instance, if growth is negatively correlated with internet access and numerical proficiency, and growth is also negatively correlated with austerity, is there any relationship between the two variables which are considered exogenous, i.e. internet access and austerity? Figure 9 shows that there is indeed a strong correlation between the two, i.e. countries with low internet access have implemented more austerity. What is it supposed to mean?

Figure 9 Internet access and austerity

pic9

A more complicated relationship than many believe?

It may mean that relationship between austerity and growth is more complicated than many economists think. In looking at growth performance during the crisis, macroeconomists are inclined to look at the specific policies which have been implemented, without asking why such policies were followed. The hypothesis that policy makers were ill advised or irrational may seem appealing to academics who tend to despise politicians. However, there may be alternative hypotheses, which the above simple statistical analysis does not seem to reject.

  • It’s not austerity which caused low growth, but low growth which ultimately caused austerity.

Put it in other terms, the countries which experienced low potential growth, because of fundamental structural problems such as literacy or low productivity growth, accumulated an excess of public and private debt before the crisis to try to sustain their standards of living and their welfare systems, which turned out to be unsustainable and required a sharp adjustment when the crisis broke out.

Concluding remarks

Austerity has certainly caused low growth but may itself be the result of the poor and unbalanced growth performance before the crisis, which was due to the lack of reform. The postponement of reforms to improve growth potential has left countries with only one solution, austerity. Austerity is thus the result of policy makers’ past inability to take timely decisions, in other words it’s the result of their short sightedness – and stupidity.
The way out of austerity is more fundamental structural reforms which increase growth potential and create the room for manoeuvre for a more gradual fiscal adjustment.

Author’s note: I would like to thank Matthias Busse at CEPS for valuable research assistance.

References

Bini Smaghi, L. (2013). “Austerity: European Democracies against the Wall”, CEPS, July 2013.

Blanchard, O. and D. Leigh (2013). ”Growth Forecast Errors and Fiscal Multipliers” IMF Working paper 13/1, Jan 2013.

Krugman, P. (2013), “How the Case for Austerity has Crumbled”, The New York Review of Books, 6 June.