Europe's keynesian dream: a neo-classical recipe for a neo-classical problem.

• Author: Sinn, Hans-Werner

A prominent view among Anglo-Saxon economists is that Europe's ailing economies are suffering from a temporary lack of demand that requires classical macroeconomic policy measures such as those implemented by the United States in recent years. If this view were correct, Europe should now be out of the woods, given that its crisis-stricken countries have been showered with fresh money from local printing presses and allowed to boost their debt-to-GDP ratios. Alas, it isn't. The truth is that Europe is suffering from a distortion of relative prices that burdens southern Europe with mass unemployment and northern Europe with bad terms of trade. This assessment does not only follow from a German ordoliberal and old-fashioned view of the world, as is often maintained, but also from plain neoclassical economics.

True, a Keynesian demand crisis prevailed in 2008-2009, when banks and financial intermediaries were hoarding liquidity and the interbank market seized up. But when the recovery of the global economy brought some relief to the southern European economies, it became clear that the financial crisis simply had exposed the above structural problem.

The distortion resulted from the euro itself. Interest rates in Europe converged quickly after the Madrid Summit of 1995 set the timing for euro introduction, triggering inflationary credit bubbles in southern Europe that ultimately deprived these countries of their competitiveness. The credit inflows were used to raise the wages of both government employees and construction workers beyond productivity, and beyond the level of comparable competitors. Wages in Greece are today twice as high, and in Spain three times as high, as in Poland, for example. From the beginning of 1995 to the third quarter of 2008, when Lehman Brothers collapsed, Spanish prices increased by 23 percent more than the rest of the eurozone's prices. Similarly, Italy revalued in real terms by 25 percent, Greece by 16 percent, and Portugal by 17 percent. In contrast, Germany, which was suffering from an exodus of investment capital, devalued by 22 percent.

As long as private investors were willing to finance the southern countries' funding gap, this situation was sustainable. However, as soon as the U.S. crisis spilled over to Europe and private capital shunned the south, the crisis hit.

Since early 2008, southern Europeans have been allowed to borrow and print themselves out of the pain, but this has not prevented the collapse...