Edmund Phelps on Why Germany is Right to Ask for Austerity

Edmund Phelps has a good op-ed piece in yesterday's Financial Times. He offers a different perspective on the crisis in Europe, arguing that it is not caused by the euro and that the fix is not to aid the insolvent in order to avert defaults.  Instead, he claims that a combination of Keynesianism and "corporatism", which he defines as, "...state projects serving cronies and vast social protection programmes, both run by elites." He argues these programs surged in the 70s and 80s in much of Europe.  By the mid-1980s Italy was running sizeable fiscal deficits and the same for France in the early 1990s.  In 1990 the Basel I agreement lowered a bank's capital requirement on sovereign debt to zero, which increased public debt.

Phelps continues, "This was wonderful in the Keynesian view: more wealth supported rising consumer demand. In the 'structuralist' view, however, it spelt trouble." Both Italy and France saw productivity growth stop in the late 90s. Incomes increased but based on debt rather than productivity. Eventually, credit markets recognized the problems and interest rates increases. Given the interconnections among European banks and the governments, all are nearly insolvent.  Phelps examines some ways in which Italy, France and Greece could move away from the status quo, but I think are unlikely to take place.

Phelps concludes by arguing that there is a split between those who want to continue with corporatism and Keynesianism, and those who want greater fiscal responsibility and a well-functioning capitalistic system. 

For anyone who has access to the newspaper, the article is worth reading and remembering.