The European leadership has announced it has agreed to a new pact on fiscal discipline with the German Chancellor Angela Merkel leading the way in imposing strict austerity on member countries in the Eurozone.

The goal is to force countries with supposedly high deficits and debt to GDP ratios to reduce them so that their deficits do not exceed 0.5 % of their GDP. But since the countries with elevated debt to GDP ratios are almost always countries experiencing high unemployment, this pact make little sense.

Europe is still mired in high unemployment (except in Germany) and is still suffering the fallout from the financial crash of 2007-2008. Imposing austerity and budget cutting is the wrong policy in the wrong place at the wrong time. It quite simply makes no sense and demonstrates the very weak hold of the politicians and their chief advisors on understanding macroeconomics and the nature of aggregate demand.

Just look at the arithmetic involved. Aggregate demand is composed of consumption, investment, government expenditures less taxes  and total exports minus imports. That is: ∑ D= C+I +(G-T) +X-M. Austerity and budget cutting involves a combination of increasing taxes and reducing government expenditures. In other words reducing the value of the expression G-T which is a measure of the government deficit. But if we do this, then aggregate demand ∑D is also reduced by at least an identical amount. Since employment is a function of aggregate demand , N=f(D), unemployment must rise because of these policies. Deliberately increasing unemployment during a deep slump is madness and bound to increase the severity of the slump and the suffering that goes with it. These may seem like harsh judgements but they are the facts.

Unless you believe that imposing austerity somehow stimulates private investment. But there is absolutely no evidence for this approach. Why should entrepreneurs increase investment if governments are cutting back ? Since the public sector cuts and increased taxes decrease aggregate demand, who will buy the new output associated with the new investment ? Rather than risk losses the entrepreneurs will more likely sit on their cash rather than risk it prematurely. Investments will be frozen out by the chilly climate and decline in aggregate demand that austerity promotes.

In the presence of public sector stimulus private investment is crowded in by the prospects of greater profits that accompanies the rise in aggregate demand even if the entrepreneurs oppose stimulus for ideological reasons. So long as the central bank defeats bond market blackmail by keeping interest rates low, public sector deficits that finance useful investments increases and sustains aggregate demand.

But in austerity the exact opposite will occur.