The European Economic Crisis: A Micro or a Macro phenomenon?

In the debate about the crisis two different policy positions play an important role. The first and politically dominant stand says that governments of EU-members should cut their expenditures. The expected effect is a decrease in their budget deficits. Although economic growth will decline in the short run, in the longer run higher unemployment implies lower labour costs, which leads to an increase in the exports. In this way the economy recovers, leading to higher tax receipts and higher production and employment levels. The budget discipline as required in the Stability Pact will be reached within a few years. The second stand says opposite: effective expenditures must be increased. Some advocate an increase in the wages, leading to higher levels of private and public consumption. Others advocate an increase in public investments. Only in this way growth will be restored and the budget discipline, as required by Brussels, reached within a couple of years.

North-EU politicians, and especially the members of the euro zone advocate the first option. Most Mediterranean countries, however, opt for the second strategy. Especially Germany and the Netherlands successfully pressed other countries to accept the first strategy. So, many European countries are cutting their government expenditures significantly now. Although economic growth declines severely, and unemployment and budget deficits rise unacceptably, the proponents still hope for an increase in exports through lower labour costs. The critique of opponents focus on the fact that exports will not rise. When so many European countries are cutting expenditures, while consumers and investors are apathetic and depressed, the increase of exports must be expected from the extra EU-trade.  Unfortunately, many important non-EU economies also have to deal with a decline in their growth. Only economies in the top of the competitiveness ranking can improve their performance through an increase in exports temporarily. This driving out of ‘bad economies’ makes the market as a whole smaller also the ‘good economies’ will suffer in the end.

In section 2 we will sketch the two theoretical approaches, which offer two different interpretations and analyses of the current situation.

Two interpretations of the world economy

In the microeconomic approach the world economy is interpreted as a large number of free and competitive markets. Every market is characterised by many demanders and many suppliers, who are constantly making decisions about buying and selling goods. Every actor is small relative to the market as a whole, and every market is small relative to the economy as a whole. In this world only economic-rational actors can survive. Those who don’t adjust to the market economy in terms of prices, quantities and qualities of goods, disappear; others take over their positions and flourish even more.  The money market is the only exception: it is large relative to the economy as a whole. So, there must be a governance system, responsible for the control of the money supply.

In the macroeconomic approach there is a world economy, which consists of a number of interrelated parts. Some parts are large relative to the whole of the economy. Other parts, however, are smaller or even very small relative to the whole. Every part shows the same characteristic: it consists of larger and more powerful parts and smaller and less powerful parts.

Over time we see that the world economy evolves in a particular way. Stages of expansion are followed by stages of recession or depression. In years of expansion some economies profit more from the atmosphere of optimism, while in times of recession the losses are unequally distributed. Sometimes a recession turns into a depression, which means that the system of free markets cannot count for the typical market mechanism, which should turn the economy as a whole into a next stage of expansion. The free-market economy fails, since private consumers and private investors are very uncertain about the medium and long-term economic development. The private actors take precautionary measures: they increase their liquidity and savings rate, at the cost of their consumption, investment and borrowing. The resulting effects on production, income, employment, and their quantity demanded for money aggravate the situation and lead to even more depressive moods. This general apathy can only be turned into an optimistic mood, if the government increases its investment. This action affects the demand for and production of goods, which has positive effects on income and employment. Moreover, it has a positive effect on the production capacity: a better infrastructure makes private investments more productive.

In the next section we will compare the two different frameworks of interpretation.

Comparison between the micro and the macro view

In the micro view a market economy, in which the government does not intervene, will always be close to equilibrium. The reason is that an economy is the aggregate of many economic and rational actors, who all are unable to affect the economy. So, small deviations from its equilibrium lead to individual actors adjusting to the new circumstances. This takes the system as a whole in the direction of equilibrium again. On the macro level we see fluctuations: an expansion turns into a recession. But individuals adjust, resulting in a turn into a next phase of expansion. If there is really a depression, the government must have intervened in an improper way – setting prices, wages or interest rates too high, for instance. Private actors lose confidence, until the government adjusts, by cutting expenditures and taxes, or by not intervening in processes of price formation anymore. Confidence of private consumers and private investors returns, and the economy turns back in the direction of equilibrium.

Applied to the current situation of the European economy governments must cut their expenditures, and reform their economies by deregulating markets to prevent a depression. Financial markets are going to trust European economies again, leading to lower rates of interest. It makes European economies more competitive relative to other parts of the world economy, which are pressed to become cheaper and improve the quality of their products. Orthodox economic static analysis assumes that this competitive process leads to an optimal use of scarce resources, and therefore to the highest level of wealth.

The macro view criticises this interpretation. Orthodox economic analysis produces many logical implications from a series of axioms, which are far from realistic most of the time.

In the first place, is the axiom saying that all actors are rational not a serious attempt to define the essence of human behaviour; it is just meant to make a distinction between economics and psychology. If we assume irrationality, we better understand, for instance, why people regularly borrow and consume and invest too much, and that irrational banks do not counter these irrational drives of people.

In the second place, is the axiom saying that relationships between humans are not social, but only economic in nature, far from realistic. It leads economic orthodoxy to a complete misunderstanding of the relationships between capitalists and workers, and between rich and poor. If an economy becomes increasingly depressed, and poverty and unemployment rises continuously, as we see in the Mediterranean area at the moment, rancour grows, which leads to a radicalisation of society. Once this negative energy will pop up somewhere, an orthodox economist will not understand the outburst as a result of economic processes. It means that societies are not peaceful market systems, but arenas in which many irrational people group together, and fight their status battles by means of decent and indecent methods. Such societies require a government with a completely different role. Powerful groups press the government to serve their interests. Less powerful groups are, by definition, unable to withstand these lobbies, and search for other weapons: demonstrations, strikes, and the formation of radical groups, which are able to fight in the streets and on the work floors. To serve the ‘general interest’ the government should organise platforms of communication where different groups can discuss important matters. In transparent confrontations the elements of irrationality and rivalry are reduced. A changing social climate – from conflict to compromise and consensus – might lead to generally accepted definitions of long-term interest of society at large. On the basis of the results of society-large communication a culture emerges that makes it possible to have a democracy, where political parties can compete with each other to have the votes of the public, and implement government policies on the basis of parliamentary majority.

In the third place, not all actors in the economy are small relative to the whole. Some firms, nongovernmental organisations and governments are large relative to the whole. It means that their actions can really affect the course of the whole. Some American banks, some German firms, some investment funds, but also some governments such as the European union are influencing the degree to which the general interest, as formulated on communication platforms, is served.

In the fourth place, the interdependence of economic activities has grown over time. In orthodox economic market theory, firms are assumed to be competitors of each other. Markets are assumed to be quite independent of other markets because of imperfect substitution and a neglect of the phenomenon of complementarity. But the process of ongoing specialisation on the global level shows that the world economy goes in the direction of one huge firm. Differently located departments send their semi-finished products to each other. At every location workers add some value to it, and transport the semi-finished goods to the next place, until it can be considered as a final good. It means that many goods become complementary, and a decrease in the demand for final goods somewhere, has a negative effect on the economic growth in many geographical areas. The consequence is the formation of a network of economic activities over the world, in which some clusters of activities are even more interdependent than other clusters.

These ongoing changes in economic patterns have brought an accommodating change in social and political patterns. Europe is a very good illustration of the fact that economic interdependence unavoidably leads to social interdependence. Individuals perceive themselves not only as a member of a nation, but increasingly as part of a broader social-cultural unit.  Europe is halfway the transformation from national to a European identity. There is a danger that big differences between North and South leads to a divide between the two regions, which is difficult to overcome. It might change the way people frame their situation. Then a person sees himself not only as a Greek, but also as a typical Mediterranean, not North-European, for instance. Investors start to collect information about economic growth and profits in North and compare the figures with those of South Europe. Politicians of North and of South Europe have their own meetings to see how their common problems can be dealt with. Fortunately the divide between North and South is not that bad at the moment, but the growth in European identity is stagnating at the moment. This is definitely at the cost of growing economic interdependence and the respective growth rates of the various members of the EU.

The way people frame their situation is very important for the interpretation of the situation and for the actions to be taken. When the world faced a financial crisis, caused by Anglo-Saxon banks, the world economy as a whole was hit and dived into a depression. The USA and China took responsibility and stimulated their spending so as to return to the regular business cycle. The EU hesitated, and especially Germany and The Netherlands stressed the relevance of cutting government expenditures and liberating markets from regulation, except the financial world.

A shift from the macro to the micro interpretation of the crisis

Why was the European Union against a spending impulse? Under German leadership the focus moved from countering the depression to improving the competitiveness of the individual members of the EU, and especially of the euro zone. In our terminology: a move from a macro interpretation towards a micro interpretation of the European depression. It also meant a change in the language in the policy debate: the macroeconomic situation was characterised by recession, not by a depression. The focus in the discussion moved from growth of incomes and employment to ‘budget discipline’, interpreted in the Anglo-Saxon liberal way. This move led to a mass of information in the media, all based on the implicit assumption that cuts in government expenditures will lead to lower budget deficits. However, the debate should be about the question whether the first or the second framework of interpretation must be considered as the most accurate reflection of the current situation. This question is the topic of the next section.

Current Situation in the World Economy

The process of globalisation has a long history already. The last few centuries we see periods of increasing international trade, interrupted by periods of increasing protection. After WW II, however, we face a long period of increasing interdependence of national economies; especially in the eighties under the influence of important breakthroughs in the field of ICT and the emergence of a large global financial sector. The interdependence of activities is not equally distributed over the world. Over the years Latin American countries have become more intensive trading partners of each other. Countries in Eastern Asia have multiplied their mutual trade. The most remarkable growth of interdependence has taken place in Europe. The establishment of the EU, and its ongoing extension, has had a strong effect on its intra-trade. When looking at trade figures it is obvious that the EU-27 must be interpreted as one economy. Especially The Netherlands is extremely tied to this regional economy.

In the end of the seventies a strong ideological movement came up, advocating the idea that free markets are always and everywhere superior to economies with more government intervention. It led to widespread deregulation of labour and financial markets, stimulating the use of the classical-liberal frameworks of interpretation again. Macroeconomic developments were interpreted micro-economically: just as an aggregate of the actions of individuals. Create as much freedom for individuals as possible, and the economy will grow again. The second framework takes into account that some persons, firms and economies are large relative to the whole of the world economy. This makes the world less stable and ‘automatic’ returns to equilibrium uncertain. When in the 16th Century the VOC decided to send ships to the East Indies on a regular basis, they didn’t have figures about European or world trade. Nowadays, we all are flooded by financial-economic information from all over the world. Everyday many people talk with many other people on the question how to interpret actual developments. In this worldwide discourse some people have more influence on the frames of interpretation than others. Again power is very unequally divided; most rich and powerful business people advocate the idea of individual freedom, since they don’t want to be limited by government rules. In other words, powerful people are inclined to go for our first framework. In contrast to this, we see that marginalised people – poor, unemployed, handicapped, low education – have hardly any influence on the processes of interpretation. They are inclined to go for the second framework of interpretation. The first group narrows the discussion to financial matters: how to institutionalise the world such, that the profitability of capital is maximised. Poverty and unemployment are not subjects to talk about, because the implicit assumption is that poor and unemployed people profit from flourishing firms. The second group focuses its analysis on economic growth, wages and employment, and considers the price of capital as a constraint, although an important one.

Two questions are decisive when choosing between the two frameworks. In the first place the question whether we are in a depression or just in a regular recession, in which automatic stabilisers in the government budget keep the economic system stable. In the second place, the question whether we can indicate which clusters of activities are too big to fail.

The difference between a regular recession and a serious depression concerns the behaviour of private consumers and private investors. If they are confident that the decline in growth rates will be small and very temporary – 1 or 2 years, for instance – their expenditures do not significantly decline when facing a decline in actual wage or profit income. If they are pessimistic about future income growth, they change their spending behaviour significantly. A decline in actual income leads to a more than proportional decline in consumption and investment. For consumers and firms hold that even if wages and profits increase again, they use their income increase primarily to improve their solvency and liquidity.

With respect to the problem of clustering the EU has been a great success the last half a century. For all members hold that their intra-trade has arisen significantly more than their extra-trade. The Dutch economy exports about 70% of their value added to other countries, whereby about 70% of its export is intra-EU trade. So the performance of the EU-economy is extremely important for the Dutch. On the other hand is the German economy the largest economy with the largest volumes of EU-intra trade. It means that the well being of the EU-economy is quite dependent of the German performance. In figure A we have presented the relative significance of Germany, the EU and The Netherlands.

With respect to the world economy there are four major economies, which all having a significant effect on its development. The EU increasingly becomes a whole – economically, socially and politically – and therefore we should take this as one economy. Besides the EU, which is the largest economy in the world, we see that the USA, China and Japan belong to the most important economies on the global level. In figure B we have presented their mutual trade.

Although their intra-trade is much lower than the EU-intra trade, we can without doubt conclude that the Big Four all have a significant influence on each other. Altogether they produce more than two third of the world production. It means that their wellbeing is decisive for the course of the world economy. Besides these economies there are a few other economies, which are somewhere between two statuses: undeveloped and developed: the so-called BRICS-countries.  The economies of Brazil, Russia, India, (China) and South Africa show impressive growth rates and are of increasing importance for the functioning of the world economy. Figure C shows, however, that their relative importance is still quite small.

Can we draw the conclusion that the world economy cannot be depicted as a competitive market with many demanders and many suppliers who are all small relative to the whole of the market? The world economy consists of a few big economies, which become increasingly dependent of each other. Does it mean that competition does not play a dominant role anymore? To answer this question we need to present a last consideration. Suppose a Dutch person starts a business, because he has a brilliant idea how to make computer chips with a storage capacity much larger than the current ones. His market is a global market, and by establishing a couple of joint ventures he can easily enter the American, Chinese, Japanese and European market. By offering higher quality and lower price his business will be a great success! If important parts of the world economy are quite stable and show regular ups (expansion) and downs (recession), the Dutch chips are taking an increasing market share, while the market is growing. But if important parts are in a depression, and also the computer chip market is declining, the Dutch chips might grow, but definitely at the cost of other producers. A few private initiatives are by far not enough to restore clusters of market economies. They will not stop the vicious downward circle, which is based on a climate of (over) pessimism. Even if a small economy like the Netherlands is able to create more optimism in the own country, they cannot climb out of the depression, since a very large part of their export markets are still in a depression.

If  the Dutch would significantly decrease their labour costs, and improve the quality of their products, they might improve their competitiveness. This might improve their economic performance a little bit: again by conquering a larger share of the declining market. But this success is at the cost of other economies, which contribute to a further decline of the export markets. Figure D shows the positive theoretical relationship between competitiveness and economic growth.

In periods of regular cyclical movements in economic growth figures, economies can move up and down the line by actively improving their competitiveness (such as Germany) or by neglecting this issue (such as Greece). But in times of depression, as Europe is facing now, attempts of countries to improve their competitiveness leads to a downward shift of the line.

Now the European Commission has accepted the Anglo-Saxon liberal idea of budget discipline, and member-states has obliged to cut their governmental spending, the line has shifted downwards. As always is the impoverishment unequally distributed. The figure shows this phenomenon by changing the slope of the line when the line shifts.

Now it is clear that the European economic crisis results from a failure to see and counter the depression. Private persons or firms are too small to solve the prisoners’ dilemma: every country has an interest in spending neighbours, while itself are improving its competitiveness. Only the (European) government can solve this problem by a huge investment impulse. This impulse must be financed by the ECB and other European central banks, so as to avoid increasing governmental debts. Especially countries with a surplus on the current account of the balance of payments should actually implement these investment plans. This is the only way to break through the climate of pessimism, which is responsible for the depressive reactions of private consumers and investors.

Conclusion

Growing interdependence leads unavoidably to cluster definition and interpretation. Now there is a world economy, it can be in depression. The same holds for Europe: now it exists in the minds of the people and increasingly also in statistics, it increasingly plays a role in society, and it increasingly needs management and control.

With respect to the European Union we can establish two important characteristics:

(1)It faces a depression, especially because it failed to solve the depression of the world economy of 2009;

(2)There are important differences in competitiveness between the different EU-members, especially a difference between North and South Europe.

The first framework of interpretation assumes that the EU-economy will recover if all members are trying to improve their competitiveness. The second framework of interpretation assumes that the EU-economy only recovers if the EU as a whole develops an anti-depression policy, and stimulates government investments.

We can draw the conclusion that the first interpretation is a dangerous one, and can lead to another global depression, since the EU-economy is definitely large relative to the whole of the world economy.

It goes without saying that every economy should evaluate all its institutions regularly, and definitely also the efficiency of its wage policy and of its government expenditures, like every family and every firm ought to do. But if efficiency considerations lead to lower wages and lower government expenditures, the government should compensate for the loss of effective demand, especially in times of depression, as is the case for Europe now.

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