Why is European Economy Failing?

by V Kumar in Economics, June 10, 2010

Even though the global crisis arose in the United States, the region that looks most vulnerable today is Europe. To understand the reasons, we need to understand the genesis of the crisis, government interventions as well as how it affects Europe. The remedies require a shift of focus from managing expectations to a long term optimization of economic efficiency.

What the British Prime Minister David Cameron told his countrymen on Monday about the state of his country’s fiscal health is something that most long term observers have been concerned about for a long time. In fact, ever since the Governments across the globe took the plunge of fighting recessionary trends with a spending spree and multiple bail-outs, there has been a lot of concern as to whether such reactive measures can actually push the economy enough to take it out of the troubled waters of global crisis. As the events unfold in Europe, we now know the answer. Governments are fighting a losing battle, most of all in Europe.

The theoretical justification of resorting to fiscal expansion as a measure to fight the crisis arose largely from its capacity in modifying and improving expectations.

Role of expectations in Financial Crisis

As we all know, almost every economic crisis has a pinnacle that is purely derived by the self-fulfilling prophecies formed of expectations of impending disaster. Whether it is a traditional bank run, an amplified downward spiral of a usual business cycle or an asset market meltdown, they are all a result of market participants rushing into panicky conservatism that includes shunning all risks, withdrawing their resources from business and finally bringing all economic activities of consumption and production to an abrupt halt. To understand things from a different perspective, markets and businesses are all about taking risks, and when the perception of risks are enormously magnified, economy suffers a massive slowdown. It was exactly such panic that was threatening the world, and that is why, the response of the Governments to take the plunge and reassure the economic community was absolutely justified, to the extent that it was directed to cool down the tempers and mitigate the fears of economic participants.

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Unfortunately, such bail outs and economic boosts that were resorted to by the Governments had a significant downside that was largely downplayed at the time when they were being resorted to.

Only market efficiency matters in the long run

While expectations rule the economic decisions today, they matter only in a short run. In the long run, it all comes back to the actual efficiency of the economy that is derived from the optimization of the resources that are allocated among the various sectors of production and consumption. As the basic principles of economics tell us, the free market has an inherent capability of achieving allocation efficiency. Unfortunately, the moment Governments enter, this inherent efficiency is lost. So, when you have Governments pumping in Billions of dollars in global economy, it creates liquidity, it creates demand that creates consequent supply and even some jobs, but it is all done without achieving market efficiency. Thus, once the initial wave of optimism disappears, people find themselves in a state where neither production nor consumption is optimized as per their needs. In simple words, what is available to people is of less utility than it costs them, and what they actually want is not available within the cost that they can afford. This inefficiency is the virtual bane of all recessions.