Monday, January 23, 2012

What's wrong with Europe?

If you've been reading the news over the past few months, you may be convinced that the problem in Europe is that certain countries spend too much. Specifically, countries like Portugal, Ireland, Italy, Spain, and especially Greece have governments that are wasteful and spend a lot more than they bring in. There is also a political component to this idea, the stronger countries in Europe (Germany) believe that these other governments should learn to be more fiscally responsible. This uncertainty has led to large increases in the cost of borrowing for these countries (costs that are most likely impossible for these countries to meet).

So is this all true? Do these countries spend too much and is that how they got into this mess? The simple answer: NO!

For those who don't remember (or would like to forget), we experienced a global financial crisis in 2008. When there is a recession, growth slows and as a result government revenue dips. Even if expenditure remains unchanged, there will almost definitely be a deterioration in a country's debt levels. Now some countries were hit harder than others (China, for example, experienced a minimal slow down). The European countries seemed to recover from the crisis weakly and as a result financial markets overreacted by driving interest rates on sovereign bonds higher and higher.

The real question in all of this is not how to get these countries to cut spending, it is how we can help them recover and prosper. Increasing demand is the solution. Increase demand and the rest of the problem will take care of itself. What is increasing demand and how can it be done?

In order to make itself relevant again, Europe needs to look to the emerging market countries like China, Brazil, and India. This may be difficult pill for the former colonizers in Europe and America, but yes, I am telling you to listen to the countries that you left for dead hundreds of years ago. Many of these countries don't have enormous financial sectors (the US financial sector has gone from 4% of GDP to 8.4% in 2008).

Take a look at bank assets as a percent of GDP for the following countries (a simplified measure, but an interesting one nonetheless):

Many of the world's advanced countries need to return to real production. This means spending on research & development and bolstering high technology industries. Until this happens, Europe and the rest of the "developed" world will continue to falter.

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