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Austerity is not an inherently a bad economic policy.  Rather, it is bad when there is a monetary contraction.

There are two primary ways that money is created in most developed nations:

(1) Lending activities of banks, and
(2) Government fiscal policy

If a government runs a deficit, new money is created.  Likewise, if a government runs a surplus, money is contracted.

The lending activities of banks are based on market interest rates and the rate they can borrow from a central bank.  If a central banks allows this borrowing rate to become too low [monetary policy], banks will lend out more, creating an excess supply of money and leading to inflation.  If the central banks allow the borrowing rate to become to high, the opposite result will occur, and we will have deflationary pressures.

In the eurozone, one of the problems is that fiscal policy is conducted completely at the national level, while monetary policy is conducted at the eurozone level.  This differs from the United States where the two are both conducted at the Federal level.

One consequence of this is that monetary policy for the different nations should vary significantly, but in reality, they all have to run the same policy.  This creates a situation where Spain has a permanently tight monetary policy (i.e. money supply is contracting and creating deflation) whereas Germany has a permanently loose monetary policy (i.e. money supply is expanding and creating inflation).

The eurozone politicians have largely misdiagnosed the problems.  They believe the problem is “reckless spending”, rather than monetary contraction.  The solution they have prescribed is that the nations like Spain and Portugal cut fiscal policy (thereby resulting in more monetary contraction).

In other words, austerity is a double-whammy for Spain and Portugal.  Money supply is contracting both due to monetary policy and fiscal policy.  Meanwhile, Germany sees an expansion in money supply from monetary policy and has left its fiscal policy in tact.

This is not a sustainable solution.  However, this is not to say that austerity would be bad everywhere.  For instance, you could argue that Germany should undergo austerity in order to offset the inflation from its loose monetary policy.

Likewise, the United States would probably be OK if it were to implement a gradual austerity plan.  Remember, the US is much different than Spain, in that we could actually use monetary policy in order to offset the monetary contraction from cuts in fiscal policy.  The real problem in Europe is that the nations that have a monetary contraction from tight monetary policies are also being forced to undergo a second dose of monetary contraction from tightening fiscal policies.

The Solution to the Eurozone Crisis

While my opinion is that the eurozone nations would be best served by an outright euro dissolution; if they want to preserve the Euro, the best solution is to force Germany, Netherlands, and the “current account surplus” nations to undergo fiscal austerity, while allowing the Spanish, Portuguese, and Irish to run fiscal deficits, financed by Eurobonds.   This would help offset the wealth transfer that has been occurring via the singular monetary policy.

In my view, the best way to run a fiscal deficit is not via excess government spending, but rather, through tax cuts in Ireland, Spain, and Portugal.