A solution for the eurozone? Listen to the people, not to the markets.

For 40 years, there has been a tug of war between government in democracies and what we may call “the other government.” By the latter I mean, of course, the financial markets. James Carville highlighted his concerns when he announced that in the next life he would want to be a bond trader. Alan Greenspan followed the bond markets religiously for signs of increased or reduced inflationary expectations.

Now Europe faces the threat of a financial market rebellion. Democracy has spoken loudly in this weekend’s elections on the Continent and in England. Voters said, "We have had all the austerity economics we can take."  They threw over Sarkozy in France and many Conservative and Liberal candidates in England. In Greece they ran for the extremes. The moderate liberal Pasok party won the least votes in memory, but it may yet form a coalition to run a new government. Italian election results will be in soon.

And democracy is working! The instinct among those in the financial markets is that democracy usually reflects the weak-willed demands of the public. But the public is generally right this time, and it has been many times before. Austerity economics is self-destructive when economies are so weak.   

Yet of course the financial markets’ initial reaction to the European elections was to sell, as if austerity economics was actually working to make nations' bond payments easier to handle. It was not! But the markets fear that a new strategy will make matters worse.

Political leaders should ignore the financial markets in the short run, pure and simple. This may drive up financing costs for a while, but the eurozone should absorb those and adjust policies. The European Central Bank (ECB) ought to accommodate its needs. The right policies are stimulus from the current account countries and the end of extreme austerity in the periphery. Wages should rise in the eurozone core and stabilize in the periphery; they can even rise from their current lows in places like Greece. The 17-nation Eurozone or the 27-nation EU should issue jointly backed bonds to provide social safety net support to the financially weak nations, to raise demand for them and get their economies going, while reducing the extreme financial pain and sacrifice that now jeopardize social stability. As examples, the Greeks voted for extremist parties, the Le Pen party did well in France, and the Tea Party runs amok in the U.S. Austerity fever even grips Washington, which makes the November election especially important.

What the crisis requires is elected government, not bond trader government. Any idea that the financial markets are rational should have been discarded four years ago. They have been absurdly wrong for decades. In the U.S., they persistently overestimated future inflation by driving interest rates too high compared to the CPI and the GDP deflator. Greenspan treated them as the height of rational forecasting, when indeed they were simply following the latest conventional wisdom. In my informal opinion, he used long-term rates as a guide to policy. Now the ECB remains too tight as well. In the U.S., the “rational” bond traders actually traded what they thought the market would think, rather than what rational foretellers of the future would think. It was Keynes’ beauty contest analogy—choose the woman you think others believe is beautiful. The belief that the markets were right was the fallout of extreme efficient markets theory.

The media too often treated the markets as rational as well. Bond traders implicitly endorsed austerity economics until fairly recently, and the media usually reported them as being right. The supposedly sophisticated financial media (with some noted columnists as exceptions) wondered what could possibly work if not austerity. Now there are signs that the press is waking up to reality and realizing that it, along with the financial markets, is not working.

There are some signs of the ice breaking. The German finance minister announced it was okay for German wages to rise. They have actively restrained wage growth to make their exports more competitive for over ten years. The main sources of their demand were the European periphery, where wages were rising a bit due to a property bubble caused by irrationally low interest rates offered in the financial markets. But there are still signs of backward thinking. Many in Europe think of growth policies as nothing more than making labor markets more competitive through deregulation and reduced wages. As if the more flexible labor markets in the U.S. are leading to rapid recovery.

In sum, what’s needed in Europe is fiscal stimulus, a more accommodative ECB, social transfers from rich states, higher wages in many nations, a change in the silly EU agreement to keep deficits absurdly low, and industrial policy to gear capital investment across the continent, free of prejudice and nationalistic tendencies. The elections may bring some of this about. Then, once policies are working to support growth and reduce financial burdens as tax revenues rise, the financial markets will at last respond constructively. They must be waited out for now.

To put it most simply, what’s needed is the will of the government of the people to ignore the financial markets and stop treating them like a more rational government than democracy itself.   

Roosevelt Institute Senior Fellow Jeff Madrick is the Director of the Roosevelt Institute’s Rediscovering Government initiative and author of Age of Greed.

Banner image courtesy of Shutterstock.com.

FDR once thought austerity was the answer, but he quickly learned how wrong he was.

As European leaders watch their austerity measures generate economic setbacks and pain at the polls, they're re-learning a lesson that FDR also learned the hard way: Balancing a budget during an economic crisis might sound like a nice idea in theory, but the real-life consequences are a killer. While FDR is today remembered as a president who embraced Keynesian economics with programs like the Works Progress Administration and the Civilian Conservation Corps that helped lead America out of the Great Depression, he started out as something of a deficit hawk. To explain this forgotten chapter in history, our partners at the FDR Library have put together this illuminating (and perhaps surprising) resource on Roosevelt's evolving fiscal policy, including copies of some original documents from the period.

They note that "FDR began his 1932 campaign for the presidency espousing orthodox fiscal beliefs" and "believed that a balanced budget was important to instill confidence in consumers, business, and the markets, which would thus encourage investment and economic expansion." But as the severity of the Great Depression became clear, he recognized that emergency relief programs were a necessity no matter the cost. Speaking at a campaign rally in 1936, he declared that "to balance our budget in 1933 or 1934 or 1935 would have been a crime against the American people... When Americans suffered, we refused to pass by on the other side. Humanity came first." As the economy began to improve, he eventually gave in to conventional wisdom and tried to cut back on spending, triggering the so-called Roosevelt Recession of 1937.

Duly chastened by the painful effects of his attempt at balancing the budget, FDR was persuaded to embrace the theories of John Maynard Keynes and called for more deficit spending beginning in 1938 and continuing throughout World War II. His change of heart culminated in his famous speech calling for an Economic Bill of Rights in 1944, in which he said, "We have come to a clear realization of the fact that true individual freedom cannot exist without economic security and independence. 'Necessitous men are not free men.' People who are hungry and out of a job are the stuff of which dictatorships are made."

As Roosevelt Institute Senior Fellow David Woolner has noted, what's important about this story is that FDR learned from his mistakes and changed course when he saw that orthodox economic theory wasn't working. The question is, will today's leaders show the same wisdom and courage?

Click here to read the FDR Library's full explainer, "FDR: From Budget Balancer to Keynesian."

Austerity policies are the last thing Europe's economy needs, and voters are making sure their leaders get the message.

Can democracy be raising its wonderful, if often lazy, head in Europe? Too often there is skepticism that democracy itself -- the will of the people -- can lead to wise economic decisions and that the American founding fathers were all fearful of the rule of the masses. I have long held the opposite view.

We all know examples of populist uprisings that have failed. The French Revolution was hardly an adulterated success. Populism in the U.S. in the 19th century led to many an ugly idea and many a bad economic solution.

But democracy creates demands for more equal wages, for social goods that reinstate confidence in a nation, and for the spread of opportunity. Democracy often also demands rights for minorities. It was democracy in America that fostered progressive income taxes, Social Security, Medicare, and government financing of education and roads. In my view, equal and strong wages are a source of growth, not a disadvantage that reduces profits as many orthodox economists see it. There is no growth without adequate demand. After 40 years of neglecting this basic idea, it is making a comeback.    

Now the people of France may be saying they have had it with austerity. They may well vote out Sarkozy in favor of the Social Democrat Francois Hollande. Hollande beat Sarkozy in the first run-off and, according to the pundits, is likely to win the two-person run-off in two weeks. And Hollande is running an anti-austerity and anti-big finance campaign, if a mild one. Can this break the ice and reverse the trend toward austerity? One former European leader I spoke to thinks it could.

But there is more than just a reaction against austerity in France. The Netherlands is dealing with a backlash against its austerity programs, and the Dutch have been stalwart supporters of German single-mindedness on this issue. The prime minister felt obliged to resign. Even in Germany, the Social Democrats who are increasingly voicing concerns with Angela Merkel’s policies will gain more confidence. There are left-wing soundings in Spain as well.

All this is refreshing and highly welcome. Austerity policies are dead wrong for Europe right now. It is sliding into serious recession, and it may eventually upset the fragile U.S. recovery. The rebelling left is correct about economic policy, even if it is most motivated by economic justice. Could democracy and justice be policies for prosperity? Start believing again.

The French election, however, provided another reason to end austerity. The extreme right of Le Pen received one out of five votes -- a major victory. In times of economic adversity, anger toward ethnic minorities like Muslims only rises. Deep recession is the fertile ground of totalitarisnm and bigotry. All the more reason to reject austerity and shake up Euriope.

How naïve, you say. The financial markets already gave their answer. They are selling everything except German bonds, it seems. That is a first blush reaction, of course. And many, including American business reporters, will say that this shows how silly the French are to think they can buck the austerity approach. Of course the U.S. did buck it, and if not growing with abandon, is recovering. The British adopted austerity, and despite a falling pound that has stimulated exports as well as a very loose moentary policy, its economy is floundering. What are the markets talking about?

If only the financial markets were as wise as the people can be. But that is my ace in the hole. I think even bond traders have begun to understand that austerity is now self-defeating. What they may be most nervous about is a serious political break in the eurozone that forestalls more advances of credit to the struggling nations and any chance to develop Eurobonds to supply social transfers to ease the burden on the periphery. But austerity is not the answer. The more governments cut, the further away move the goal posts for fiscal balance. Many more policy moves are required, but at least this is a start. Who knows? The markets may even rebound some this week.

Roosevelt Institute Senior Fellow Jeff Madrick is the Director of the Roosevelt Institute’s Rediscovering Government initiative and author of Age of Greed.

Image courtesy of Shutterstock.com.