Alasdair Macleod, publisher of Finance and economics.org, sees little room for a happy ending to the worsening European credit crisis.

In this interview, he builds on his excellent synopsis from earlier in the week that detailed how the crisis originated, essentially embedding a fundamental structural shortcoming into the entire Eurozone construct starting back in 1997. This flawed monetary model was exploited for temporal gain and it worked very well as long as the pie was expanding and nobody was looking too carefully at the mounting imbalances created as it chugged along beautifully. Everybody was getting rich on their Mediterranean villas going up in price almost daily.

This whole thing was bound to work until, mathematically, it couldn’t work.

The process of growing sovereign debt at a much higher rate than national income year over year over year was bound to encounter a mathematical limit at some point. That time has arrived.

How did we go wrong? How should we repair this? These are good questions that the European leaders are *not* asking at this stage. Instead, they're choosing to do all they can to perpetuate the status quo - focusing on keeping things together just through the next quarter, through the next election cycle. And it clear that their best efforts are meeting with less and less as the situation worsens.

In this interview, Alasdair provides a very detailed update on where things stand in Europe and what to expect next. Most notably, he paints a picture of a lot of very well-meaning, very anxious people who -- tragically -- are diligently applying the wrong solutions to the incorrect diagnosis.

There is one big element of this, which nobody had addressed because they don’t understand it. If you’re an Austrian economist you will understand it. If you not, you won’t. And because governments are populated by economists who are not Austrian, then they don’t understand it and they won’t understand it.

That is this: if you try and measure an economy by GDP, all you are measuring at the end of the day is the amount of money in the economy. It is not a measure of economic progress. This is a very, very important point. And, the reason it is relevant is that so long as you say we need GDP to not fall -- which is roughly what we’re talking about as far as the problem that the officials see; they don’t want the economy to fall because it threatens taxes and all the rest of it -- if they’re measuring it by GDP, then they are using the wrong metric to come up with any solution.

Now, we’re in the real world and we’re trying to seek a solution to the problem. You don’t do that by concentrating on an accounting identity. This is the point that nobody in the system seems to understand. So far as I am aware, nobody is yet discussing it, but this is why I think virtually anything they do is almost certain to fail.

Now, if we take a step back, the one thing that is wrong with the European Union -- and most of the other advanced nations by the way -- is the size of government. There is a myth that government can intervene and improve things. It can’t.

As you rightly point out, one side that isn’t looked at is that government spends money on subsiding industry, paying out welfare and so on and so forth -- but that money’s got to come from somewhere. Is it being taking away from the productive economy and being injected into something less productive or not productive at all. They’re destroying savings and therefore the ability of an economy to actually progress itself.

So, at the accounting identity level, governments can and actually do push up GDP because GDP incorporates government spending at cost in the provision of services and all the rest of it. That is part of GDP. So, if government increases it’s spending, GDP goes up. You rightly say, it excludes the other side, so where does the money actually come from?

So, we actually do have a huge problem in understanding what the problem is and therefore how to resolve it. I think that the consequence of that is that the crisis is likely to drag out a lot longer than it would otherwise because they are bound to resist the obvious and that is to cut government spending. You really need to slash it the whole way across the board. So they will resist that because the economists will tell them that if you cut spending across the board, then you’re going to cut GDP which means that your tax take is going to go down and you’re just going to make the problem worse. That unless you print money to offset it, you’re going to create a huge great deflation.

But actually, what they need to do is to cut the government spending and remove the distortions from the economy so that the economy can actually recover itself. Now, you mentioned Iceland earlier. I think you know that what the currency did is a slightly separate thing from what happened in Iceland itself. The government hadn’t resorted to do anything. It couldn’t interfere. It stood back and everybody understood they had a problem, a huge great problem. They knew they couldn't expect the government to solve the situation and that they had to look after themselves..

They’ve done that and the result is the economy has turned around. That is what we need to happen in Europe. But, they are going to resist that process till the politician’s dying days, and that is really the problem. They are now getting in the way of the solution.

Click the play button below to listen to Part I of Chris' interview with Alasdair Macleod (38m:48s):

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