Even if European politicians ‘get their acts together,’ the eurozone crisis will not be solved by a new ‘Fiscal Compact’ obsessed with austerity, i.e. tight rules for all member states on their spending. The agreement, which is intended to save the single currency, is not a “fiscal” anything, since that word usually refers to government spending. The plan is really an Austerity Compact – an attempt address economic malaise based on upside-down thinking.
And it won’t work. Because as John Maynard Keynes revealed, the worst thing that a government can do during a recession is to lower spending. And yes, all of Europe is in a recession, and probably a depression soon. Private investment spending is cyclical in nature -- too much during up-boom periods and too little during down periods. That’s why government spending must act as a counter-balance. Instead, what we have seen is government actions fueling private sector spending (with lower interest rates and lower taxes) in boom periods (like the 1990s), and now withdrawing spending during the recessionary period when there is not enough private investment.
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