Euro zone's muddling through has implications for Asia

Earlier this year, economic data suggested that the Thai economy was on the path to recovery after last year's devastating floods.

Projected output growth was revised upward to 5 per cent for 2012. The vulnerability and downside risk from the euro zone crisis was thought to be under control. There was even a ray of hope and cautious optimism that key governments in the euro zone and the European Central Bank (ECB) would agree to readjust their stance on their "expansionary austerity" policy following the G-8 Summit last month.

In their communique, the G-8 leaders vowed "to take all necessary steps to strengthen and reinvigorate" greater growth in their economies and "combat financial stresses".

Nearly a month has passed, with several subsequent talks, but there is still no coherent and decisive policy action coming out of Brussels. The euro zone's economic muddling-through of the past two years continues.

Meanwhile, evidence from the International Monetary Fund (IMF) and the Organisation for Economic Cooperation and Development (OECD) indicates that the world's economic outlook has worsened. The UK and several other european countries are experiencing recession. The unemployment rate in the euro zone averages 11 per cent, and in Portugal, Ireland, Greece, Spain and Italy the rates are much higher. The fragile economic recovery in the US is stalling, and similar downturns are evident in large emerging economies like China, India and Brazil.

Most alarmingly, the "bond vigilantes" - investors who dump a country's bonds (sovereign debt) - have arrived, and borrowing costs in countries like Spain and Italy have surged. Large European money funds rid themselves of euro-denominated assets. Last week Spain joined Portugal, Ireland, Greece and Italy in accepting a bailout.

There are signs of the euro crisis spilling over into developing countries, not only in terms of trade but also in capital flights as banks reconsider their positions. Though Thailand is less dependent on European banks, its exports to the US and the euro zone account for one-fourth of total exports, and the two regions - more so the US - are important sources of short-term capital flows.

What are the policy implications for Thailand as the euro zone and the global economy are beset with these risks and uncertainties?

First, policy-makers need to assess and learn from empirical evidence and facts. Setting aside the inadequate institutional arrangements in the euro zone, there is a fundamental concern that the current policy - austerity first before growth, led by cuts in government spending, fiscal deficit and debt restructuring in order to boost business and consumer confidence for subsequent growth - is not the right policy. The alternative being proposed is less austerity and more demand-led stimulus for growth.

In his newly published book, End This Depression Now, Paul Krugman, the Nobel laureate and professor of economics at Princeton University, has put together a very cogent body of facts and evidence, both in the historical context and in more recent experience. He explains in clear English by translating the language of complex macro-economics into terms that policy-makers should be able to grasp. Krugman's conclusion is that the euro zone's "expansionary austerity" policy has failed. A short explanation for the failure is that these countries are facing a depressed economic situation - a sustained period of below-normal economic performance.

For those who suspect Krugman of being too Keynesian and pro-fiscal stimulus, reviewing studies from a more monetarist and austere-leaning IMF can be enlightening. Researchers at the IMF have identified more than 170 cases of fiscal austerity in advanced countries between 1978 and 2009. They have concluded that austerity policies are followed by economic contraction and higher unemployment.

One of the arguments for austerity is the fear of inflation. The inflation alarmists argue that fiscal stimulus will inevitably lead to inflation. Evidence to date suggests otherwise. Despite large monetary expansion under programmes of "quantitative easing", the core rate of inflation remains low in countries like the US and Japan and in most of the euro zone. Monetary expansion affects core inflationary pressures only when it is turned into excess aggregate demand.

Despite a rising debt ratio in recent years, Thailand still has fiscal space (with the debt-to-GDP ratio at about 60 per cent), and the core inflation rate is below 3 per cent. Thailand has room to coordinate discretionary fiscal stimulus and an accommodating monetary policy to sustain its economic recovery, relying more on domestic consumption and investment.

Kiertisak Toh is a member of the economics faculty at Radford University, Virginia and a senior fellow at the Centre for International Development, Sanford School of Public Policy, Duke University, North Carolina. This commentary was originally published in the Asian edition of The Nation.