Covid-19 and Political Economy: A New Economic Ideology for the European Union?

Hilary Hogan, European University Institute.

In the wake of the Second World War, most of Europe embraced the ideas of British economist John Maynard Keynes. Keynes argued that market forces were not well disposed towards self-regulation, nor were they inherently efficient or capable of preserving employment. These failings warranted ongoing state intervention in the form of taxation, public expenditure and borrowing. His work was revolutionary: governments would no longer be at the mercy of the boom-and-bust cycle of the free market. Instead, states could spend their way out of economic crises, by ramping up public expenditure to stimulate employment, and retreat during booms to cool the economy and allow the state to repay its borrowings.

 

But by the 1980s, Keynesianism had fallen out of fashion, overshadowed by the resurgence in support for economic liberalism – dubbed neoliberalism - championed by Thatcher and Reagan. During the negotiations for the 1992 Maastricht Treaty, which largely remains the foundation for the present-day European Union, other Member States recognised that a European monetary union was inconceivable without German support. Keynesianism had never been popular in Germany, where ordoliberalism had emerged as the dominant school of economic thought. Ordoliberalism is its own form of distinct thought within the neoliberal economic family. Ordoliberalism openly envisages a role for the state that involves the creation of competitive market through its institutions, including the legal system. Neoliberals, on the other hand, tend to argue that the market will reach natural competitive equilibrium if the state refrains from regulating – although it is often argued that this is somewhat of a fiction, and the implementation of neoliberalism requires just as much state intervention.

 

Ordoliberalism envisages a role for the state in the creation of competitive markets through its institutions, including the legal system. Monetary policy prioritises low inflation instead of employment, and an independent central bank ensures that the goal of achieving price stability is immune from political influence. It rejects Keynesian counter-cyclical economic policies, meaning that public deficits should always be kept at a minimum. While the EU is often described as neoliberal, the more accurate description is ordoliberal, as the Maastricht Treaty codified this distinct vision of German political economy. As the Treaties act as the de facto European constitution, the Maastricht Treaty transformed what had previously been  political and economic preferences into purportedly neutral, legally binding principles.

 

The Maastricht Treaty sets strict limits for government deficits and debt ratios, and largely constrains Member States from responding to economic downturns with Keynesian-style fiscal stimulus (tax cuts or public expenditure). The Maastricht Treaty excluded the EU or other Member States from assuming liability for another’s debt -  seemingly ruling out the possibility of an internal European Union bail-out. The new European Central Bank had one sole objective: maintaining low inflation. No matter how high the rate of unemployment, it would be, in theory, entirely irrelevant to the ECB.  Nor was the ECB empowered to act as a “lender of last resort” to Member States, a critical role tasked to central banks who can act to liquidise ailing governments when they can no longer borrow on the international markets. The ECB’s narrow mandate meant it had a strikingly myopic view of Europe’s economic problems that was to prove highly damaging in the wake of the 2008 Financial Crisis.

 

The end result? Europe established a partial monetary union, and defied every leading economists’ recommendation by choosing to leave out a fiscal union. The Member States had ceded control over monetary policy (interest rates) to an unaccountable ECB, which was fixated solely on the rate of inflation. They had established a single currency, meaning that diverse Member States would no longer be able to internally devalue their national currency to make themselves more competitive. Strict fiscal rules on the rate of public deficit meant that Keynesian economic policies were out of the question for ailing Member States: they could no longer spend their way to economic recovery. Nor could they rely on their European neighbours for assistance, as debt mutualisation or a central fund had been ruled out. Due to the ordoliberal ideology of the Maastricht Treaty, the only tool left for Member States who faced financial difficulty was austerity.

 

The Euro Crisis and Austerity

The combination of the single currency, the Euro, underpinned by a rigid ordoliberal ideology was to prove catastrophic for the European Union. When millions of Americans gradually began to default on their mortgage debt in early 2007, the global financial system began to unravel. It soon transpired that Europe had more banks than it needed, and its banks had taken even greater risks in an effort to stay profitable. The introduction of the single currency had also encouraged the widespread purchase of Eurozone sovereign debt bonds, seemingly under the mistaken belief by investors that all Eurozone government debt was equally risk-free. By contrast with its proactive American cousin, the Federal Reserve, which immediately took steps to boost confidence in the economy, the European Central Bank showed little sign of grasping the magnitude of the crisis it faced, or even that it had any role in remedying the situation. Its role in consolidating and worsening the crisis through its unyielding commitment to its underpinning economic ideology cannot be overstated.

 

While the ECB provided liquidity to European banks, it initially refused to countenance dramatically lowering interest rates in the way that the Federal Reserve had done and continued to be fixated with preserving low inflation by raising interest rates, which benefitted the German economy, but only made matters infinitely worse for the struggling debtor countries. Greece’s debt crisis could perhaps have been remedied early on by the ECB purchasing Greek debt. But instead, multiples bailout were agreed by the IMF and European leaders for Greek’s creditors, along with strict program of austerity: structural reform, tax increases and a dramatic reduction on public spending, amidst mounting protests from the Greek public. When Angela Merkel and Nicholas Sarkozy agreed that any new debt assumed by Member States would have conditions for early debt restructuring, requiring private creditors to bear most of the losses rather than the public taxpayer, the then President of the ECB, Jean Claude Trichet, persuaded Merkel to drop the plan.

 

When finally forced into action, the EU clung to the traditional right-wing solutions of ‘fiscal consolidation’ demonstrating the depth of its ordo-liberal commitments. Intense programs of austerity were also implemented in Ireland, Italy, Spain and Portugal. Austerity directly contradicts Keynesian economic response to recessions by radically reducing public expenditure to produce economic growth. Proponents of austerity (such as the IMF) argue that reducing government deficits inspires confidence, prompting greater private investment and resulting in economic recovery. But, as economist Joseph Stiglitz writes: “how this is happens has never been explained. Out in the real world, the confidence theory has been repeatedly tested and failed.”

 

The problems with austerity are well-documented: in order to create economic growth, there must be consumption. Economic uncertainty discourages investment. Wage cuts, redundancies and cutbacks to public services discourage spending; the natural instinct is for individuals to save. This produces a fall in demand for goods and services, and the economy contracts. The ‘structural reforms’ which accompany austerity in the name of ‘labour flexibility’ make it easier for workers to be dismissed, and incentivises the creation of insecure, low-wage employment. Austerity is not even good at doing what it is supposed to do: it is a highly ineffective means of tackling public debt, and it can take decades of redirected public money towards servicing debt repayments when economic growth through public expenditure, targeted tax on capital or a moderate rise in inflation would address the issue far more swiftly.

Austerity disproportionately harms those who rely most on public services: the lower middle classes, the working class, and the impoverished. Philip Boucher Hayes’s excellent documentary has recently brought renewed attention to the devastating human cost of austerity in this country. Austerity in many ways is a beguilingly simple idea. These Member States, the narrative went, had run out of money, and borrowing or spending during financial hardship was counter-intuitive. It is easy, when likening governments to households, to characterise spending during a recession as irresponsible. But there is a world of difference between macro-economic policy and personal financial management. Households do not have the internal capacity to lower their own interest rates, to buy their own debt or take any of the significant steps that a central governing body can do in response to recession. The language of ‘balancing books’ belongs to personal accountancy: states can and do run budget deficits, particularly during times of financial hardship.

 

Yet it was repeatedly stressed by European officials that there was no alternative to austerity, and that it was the sole means of tackling the Member State’s national debt.  Not only was that not true (as noted above, there are far better and more effective means of tackling public debt) but its premise was false. It created the impression in the minds of the public that the meltdown of the global system had been caused – or certainly contributed to by – excessive public spending by national governments. Generous welfare programs had not caused the global financial meltdown. The reason that countries such as Ireland and Spain had inflated deficits after 2008 was largely because they had shouldered the cost of bailing out the banking system.

 

The use of the term ‘sovereign debt crisis’ was a misnomer, it was, instead, a banking crisis that had been “generated by the private sector but [was] being paid for by the public sector” (Mark Blyth, Austerity: The History of A Dangerous Idea (Oxford University Press, 2013) p. 62). Even Eurozone countries which had no need to adopt austerity policies began to do so, and these “cascading effects caused other member state economies to slow down as well [and] pushed the eurozone into a collective economic downturn” (Ashoka Mody, Eurotragedy (Oxford University Press, 2018) p.286). All in all, the European Union took nearly six years longer than the United States to recover from the economic downturn.

 

Covid-19 and European Union

During the Euro Crisis, resistance to austerity was characterised a denial of reality; a failure to accept what was the only means of tackling the crisis. But it seems as though there has been a remarkable shift in thinking. Traditional advocates for austerity – such as the IMF – are now recommending government spending as the best means to tackle the consequences of the Covid-19 pandemic.

 

In March 2020, European Union fiscal lending rules were suspended entirely by the European Council, who invoked the general escape clause in the Stability and Growth Pact, noting that “flexibility” was needed through “discretionary stimulus” to cope with the economic fallout from the pandemic. The European Commission has recently suggested that this could last into 2022. Ordinarily, budgetary deficits cannot be greater than 3% of GDP or public debt larger than 60% of GDP. The 2011 Fiscal Compact Treaty further mandated Member States to avoid budget deficits by running a surplus or keeping their budgets balanced. Those rules have been abandoned, in favour of mass government spending through income supports for individuals and industries, and investment in public services, particularly health.

 

The transition is remarkable. The European Union is approaching the Covid-19 pandemic in a radically different way, accepting that spending – not austerity – is the best means of salvaging Europe’s economies from the wreckage of Covid-19. This is a welcome approach, not least because it seeks to buffer the European public from the worst of a crisis which was not of their making. According to Keynesian thinking, cutting tax rates or boosting public expenditure creates a ‘multiplier effect’ as individuals have more money to spend or invest, which stimulates economic recovery. 

 

The threat of raising income tax rates and curbing public spending to ‘pay for’ Covid would be misguided, not least when the government can benefit from record levels of cheap borrowing. Now is the time for the State to undertake major investment in areas such as housing, healthcare and education, and to make major inroads in tackling climate change. These investments will be particularly necessary to bridge divisions that the pandemic has sharpened. Many in the professional classes who can work from home have kept their income and have record levels of savings. By contrast, many small and medium sized businesses, the self-employed, those working in sectors such as hospitality, tourism, entertainment and retail have been financially devastated. These sectors are also more likely to employ young people, who were already struggling with a housing crisis and own a tiny fraction of this country’s wealth.

 

Even before the pandemic, economist Thomas Piketty was able to demonstrate in meticulous detail that the world was experiencing drastic levels of income inequality akin to a new Gilded Age. This has led to mounting awareness that the wealthy have simply not paid their fair share, aided by low corporate taxes and systems of tax havens. A major welcome development is US Treasury Secretary Janet Yellen’s plan for a global corporation tax - especially as targeted measures aimed at improving the fortunes of the bottom are far more likely to be spent and reinvested in the economy than tax breaks for the wealthy. Ireland will have to rethink its own approach to corporate taxation: Deputy Joe O’Brien’s suggestion for a once-off solidarity tax is strong start.

 

Economist David McWilliams wrote recently that there is a monetary revolution underway, as the Biden administration appears to be embarking on the kind of Keynesian fiscal stimulus not witnessed since Roosevelt’s New Deal. But there is also a European constitutional revolution underway. How do the European Union’s actions square with its founding document, the Maastricht Treaty? The answer is they do not. If its foundational economic principles are perpetually suspended during a crisis, it is a fairly damning acknowledgment that they are not fit for purpose.  Europe has implicitly abandoned ordoliberalism and its reliance on austerity and reached for the Keynesian handbook. We are witnessing a form of de facto constitutional change, an abandonment of the principles Europe claimed it could not budge from during the Euro Crisis. This suggests that the European Union is beginning to acknowledge what many have argued: its underpinning economic ideology does not work, at least not without inflicting immense human suffering. 

 

Hilary Hogan is a Ph.D. candidate at the European University Institute in Florence. Her research examines the link between economic liberalism and the rise of populism in the wake of the 2008 Financial Crisis.

Suggested citation: Hilary Hogan, ‘Covid-19 & New Economic Ideology for the European Union?’ COVID-19 Law and Human Rights Observatory Blog (27 April 2021) https://tcdlaw.blogspot.com/2021/04/covid-19-new-economic-ideology-for.html