As Europe's leaders stumble toward financial disaster, terrifying investors and risking a worldwide recession, a lot of the blame can be traced to a peculiar economic notion that economists call "expansionary austerity."
So far, the evidence is strong that this idea not only doesn't work, but is severely undercutting the economic recovery in Europe, where it has been an important influence on policy, especially when it comes to heavily indebted Greece.
The notion that you can simultaneously slash deficits and stimulate growth is "a very hopeful way of looking at the world, but unfortunately, it's not based on anything ever seen in economic history," says economic forecaster Peter Berezin, managing editor of the Bank Credit Analyst.
Now, Berezin suggests, the fate of Europe depends largely on whether that region's leaders will let go of their stubborn infatuation with expansionary austerity or follow it right over the edge of a financial precipice.
Think of this idea as a kind of Bizarro Keynesianism. Instead of supporting a stumbling, indebted economy with enough public spending to sustain demand until the private sector heals, governments slash spending.
The theory is that this show of fiscal discipline unleashes such confidence among consumers and businesses that they spend and invest more, boosting growth.
The notion that austerity can spur growth isn't crazy, and it can work well under the right circumstances. But these are not today's circumstances.
There's research suggesting, for example, that if a country's growth is already strong or if there's some other support for the economy, such as plunging interest rates or soaring exports, then cuts in government spending can indeed boost confidence among residents of a heavily indebted country,
It seemed to work in Canada during this country's mid-1990s campaign to slash deficits, and there are many other such examples cited by some economists. But they involve countries where growth was strong or where it was supported by factors like falling interest rates, sharp currency devaluation or rapid growth among trading partners.
When you're talking about countries caught up in a stubborn worldwide slump, the situation is very different. Not surprisingly, withdrawing government support when the private sector is already weak just seems to kneecap the economy.
That's what has happened in Greece, an admittedly profligate country where political leaders piled up huge debts and lied about them, leaving the rest of Europe to either bail it out or risk the collapse of its banking system, which is loaded up with an unknown quantity of toxic Greek government bonds.
The response thus far has been to offer a bailout, but to condition it on strict austerity measures designed to slash Greece's debt-fuelled spending. If expansionary austerity worked, this should have unleashed a wave of business investment and consumer spending as Greeks noticed the new prudence of their political leaders.
In fact, this has been a catastrophe for Greece, a little like imposing a vigorous exercise regime on a person who's already gravely ill. Making matters worse, the inflation obsession of the European Central Bank has caused it to raise interest rates to rein in mild inflation in the region, ignoring the deadly effect this has on Greece and some other severely stressed economies.
Two years after most other countries began climbing out of the recession, Greece's economy is still sinking. It's forecast to decline by a disastrous 7.5% this year and next. Of course, this makes the debt problem worse, not better, since the debt-to-GDP ratio tends to rise, not fall, when tax receipts are plummeting and social welfare costs soaring.
It is now clear that Greece will not meet the deficitcutting targets required to qualify for the next slice of its bailout, due to be paid by the middle of this month.
Will the so-called troika of the European Central Bank, European Commission and International Monetary Fund decide to overlook this technical failure, or will it yank away Greece's lifeline and let the European financial system pay the price?
Berezin and other analysts are betting that when it comes right down to it, they'll blink and keep the bailout funds flowing. This won't fix Greece, but it will buy time.
In the end, Berezin is betting that European leaders, including at its central bank, will abandon their strict adherence to austerity. He guesses the trigger for this will come when some large bank in Germany or France is threatened with collapse as a result of the festering government-bond crisis.
Some sort of more durable bailout for Greece will be joined by action to protect other vulnerable countries like Italy and Spain by having the European Central Bank commit to buying as many of their troubled bonds as necessary to keep borrowing costs reasonable, Berezin believes.
To the ultraconservative ECB, this will be heresy, but it should work, since Italy and Spain should be capable of working down their debts as long as their borrowing costs aren't driven sky-high by speculators.
But the solution won't come cheaply. By dragging their feet for two years while the crisis worsened, Europe's leaders have virtually guaranteed at least a mild recession in the region, Berezin fears. As well, he conceded, there's always a small chance that the austerity infatuation will win out over common sense, leading to very ugly consequences.
