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Professors Kenneth Rogoff and Carmen Reinhart, authors of an economic study on the relationship of government debt to growth, in which a provocative new paper claims to have found basic errors.


This was the week that austerity died.

It did not need to. The dire effects of austerity should have been offset by job-creating reforms. But those proved elusive as feckless European politicians handed victory after victory to entrenched interest groups. Layers of killer bureaucracy took over from there and the result was a jobless non-recovery and a lot of angry voters ready to burn the place down.

A couple of months ago, I interviewed George Provopoulos, governor of the Bank of Greece. He had criticized the Greek government for years for promising reforms that never came as harsh austerity turned the country into a hell chamber.

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"Fiscal consolidation meant more taxes and less spending, and that means you depress levels of economic activity," he said. "Structural reforms are the only way to counteract."

Indeed. Now Europe has backed itself into a corner. Most of the euro zone countries, especially those on the Mediterranean frontier, but also France, are fed up with endless austerity. That's fine. Austerity and recessions do not mix well. Here's the problem. Austerity was never meant to be a policy – it was a necessity that was to lead to something better. But nothing better came, because the structural reforms required to make economies more competitive and juice up the job market went missing.

So budget deficits will remain intact, lifting debt to gross domestic product ratios to potentially dangerous levels. Recessions will not disappear any time soon. In a year or two, maybe less, a new debt crisis will erupt. Do not be fooled by the falling sovereign bond yields in Italy and Spain.

Commodity prices are down along with the world growth outlook. The lower yields reflect less worry about inflation and the likelihood of a European Central bank rate cut next week as much as the removal of the immediate existential threat to the euro.

The calls for an end to harsh austerity have become roars. It started last week, when Harvard economists Carmen Reinhart and Kenneth Rogoff found their work discredited by rival academics.

Ms. Reinhart and Mr. Rogoff determined that national debt loads above 90 per cent of GDP almost always led to greatly reduced growth. Their rivals found no such relationship (and also accused the duo of data "coding error"). Suddenly, austerity's intellectual underpinnings were cut away.

Since then, Spain, where the jobless rate has hit a record 27.2 per cent, has begged for mercy from its paymasters in Brussels. It appears the European Commission will give Spain another two years to meet its deficit targets. France, with the surprise backing of austerity-mad Germany, seems on the verge of getting a similar grace period.

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On Monday, EC President Jose Manuel Barroso said, "While I think this [austerity] policy is fundamentally right, I think it has reached its limits."

Two days later, Italy's new prime minister, Enrico Letta, used his maiden speech to call for an austerity truce. "Europe's policy of austerity is no longer sufficient," he said.

It is Italy, not Greece, that has highlighted the dangers of combining austerity with a lack of reform.  Greece is actually becoming competitive again. Its unit labour costs soared by more than 30 per cent between 2001 and 2009. Since then, almost all that increase has been reversed and Greek exports are soaring.

Italy is the euro zone's only big economy where costs have not declined since 2009. As a result, its manufacturing base, the second biggest on the continent, after Germany's, is getting obliterated – industrial production is down by a quarter. According to the Economist, Italy has lost 31,000 companies since the start of the year alone and an average of 167 retailers vanish every day.

Fiat is losing money in Italy, where annual car sales are down about 20 per cent. The recession is deepening, unemployment is 12 per cent and rising, and house values are set to fall off a cliff. In many ways, Italy's downturn is worse than the Depression years of the early 1930s. Its debt-to-GDP ratio is 127 per cent, an unsustainable figure, and it's rising as denominator in the ratio – GDP – shrinks.

Italy is running out of options. The one strategy that could save it – a revolution to free up the labour markets, break down the barriers to competition and gut the numbing, and hideously expensive, regulatory, judicial and bureaucratic regimes – is one that is both acknowledged as necessary and near impossible to achieve. Any prime minister who strives to launch the Italian revolution would have to live in a bunker for fear of assassination.

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Countries like Italy and Spain which want to roll back austerity might want to look to Britain for inspiration. To be sure, a lot of Britain's numbers are going in the wrong direction.

The budget deficit, at an estimated 7.1 per cent of GDP this year, is more than twice as wide as Italy's, and the debt has climbed to 90 per cent of GDP. Britain's manufacturing base, too, is in relentless decline.

So what's to like about Britain? Its jobless rate. It's only 7.9 per cent, a fantasy figure for Spain, Portugal, Italy and Greece.

It's that low in good part because Britain went through a labour and regulation revolution in the Margaret Thatcher years and beyond. It is easy to fire employees and easy to create jobs and new companies. It costs only £100 (about $158) to incorporate a new business. The country, as a result, is a magnet for jobless Europeans who are fed up with Everest-scale employment barriers in their home countries.

Austerity has run its course; that's the good news. The bad news is that unless economic reform is taken seriously, the debt crisis monster will trample the euro zone once again.

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