European Spillovers, by Paul Krugman, in NY Times: Wolfgang Munchau suggests a reason for European misjudgements — he argues that European leaders have failed to take account of the fact that Europe, collectively, is a fairly closed economy, selling primarily to itself:
The many failures of the eurozone’s crisis response policy have a common cause: the eurozone is a large closed economy. Each of its 17 members is small and open. The political leaders who run the eurozone have a small open economy mindset – every one of them, without exception. The economists they employ mostly use small, open economy models.
It’s an interesting thesis, and I agree that the within-Europe spillovers from fiscal austerity are significant. Early on in the crisis I did some back-of-the-envelope calculations for fiscal expansion and guesstimated that a coordinated expansion had twice the bang per euro of a unilateral expansion by just one euro area economy. By the same logic, austerity would look much more attractive to each individual country if they don’t take the cross-border effects into account.
That said, I think Munchau is being too kind here. European leaders and institutions by and large didn’t even get to the point of devising policies that might have worked in a small open economy. Instead, they went in for fantasy economics, believing that the confidence fairy would make fiscal contraction expansionary. The ECB, which Munchau credits as the institution most aware of the linkages, was also the institution most dedicated to the doctrine of expansionary austerity.
In general, economists love models in which smart people make individually smart choices that end up being collectively dumb; and they especially love it when such models make a case for international policy coordination. Me too! But in the real world, bad policy more often arises from failure even to get the principles right at the individual country level. Bad economics, not adding-up constraints, is at the core of recent European foolishness.