The road to chaos

First, some context. I've written frequently about the eurozone problems and their structural underpinnings over the past few weeks. Last week's agreement by European Union leaders did nothing to change the situation, with its one-sided emphasis on stricter enforcement of budget austerity.

The outcome, an intergovernmental treaty, will create yet another layer of supranational governance in Europe to accompany the European Union, the European Economic and Monetary Union, the European Parliament, the European Council and the European Commission.

Hopes and dreams of a massive increase in the eurozone's bailout power and/or massive intervention by the European Central Bank crashed into the rocks of reality. Germany insisted that the maximum bailout power be capped at 500 billion euro, roughly $659 billion. And the ECB continues to resist all calls for it to engage in belligerent monetary financing of the likes of Italy and Spain -- pointing out that its existing bond purchase program is "limited in scope and longevity" and that there is "no possibility of greatly expanding ECB bond purchases" according to an official.

Essentially, it all boils down to this: Germany and France are asking Greece and Portugal to embark on an impossible task of "internal devaluation" to boost export competitiveness at a time of fiscal vulnerability. Greeks would take a hit to protect French and German bankers.

It won't work. You can't ask an entire country to take pay cuts and work longer hours for less at the same time you offer fewer social benefits and increase taxes. Not only will the economy not grow, but your deficits will get even worse. And your banks will get hit with more deposit outflows and loan losses.

This last point is key.

The damage done by austerity

A few months back, I wrote extensively about fiscal austerity and the damage it causes a weak economy, and showed how this related to the fierce debates in Washington between Obama and the Republicans. I warned of focusing too intently on fiscal woes and the debt burden while ignoring the need to support the economy over the short term. This was the fool's errand behind the 1937 double-dip recession that made the Great Depression so terrible.

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Instead, I recommended a focus on short-term growth (to fix the cyclical portion of the deficit) and a commitment to tackling the real, structural drivers of the medium-term budget problems, namely, health care spending. (For more, read "Why Obama needs to spend more" as well as the work of Francois Velde, senior economist at the Federal Reserve Bank of Chicago.)

The current predicament combines all these things into one fantasy, a delusion shared by elements of the Tea Party as well as the pushers of austerity in France and Germany: that you can cut your way to prosperity. You can't. New research by the International Monetary Fund, looking at efforts to close budget deficits in 17 wealthy countries since 1978, found a clear link between slower economic growth and higher taxes and lower spending.

This shouldn't be surprising, given the anecdotal evidence around us. The British economy is stagnating as its coalition government pushes through even more tightening measures. And the Greek government is experiencing firsthand the downward dynamic of recessionary austerity: Budget deficits were higher than expected for the first 11 months of 2011 as the economy weakened more than forecast, resulting in lower tax collections and higher spending on social programs.