Did Europe misdiagnose debt crisis and make it worse?

By Luke Baker BRUSSELS (Reuters) - At the height of the euro zone debt crisis, with Portugal's economy nearing collapse, the European Commission told the government in Lisbon that it had to slash wages if it was ever going to boost competitiveness and grow again. Portuguese shoemakers - one of the economy's main export sectors - steadfastly ignored the advice and found a way to bounce back while actually increasing workers' pay. It is just one of many examples Philippe Legrain, a former adviser to Commission President Jose Manuel Barroso, cites in a new book that argues policymakers misdiagnosed the crisis and ended up prescribing the wrong medicine to resolve it. He was an adviser from 2011 until resigning in March of this year, so was involved at some of the most critical moments. "The Portuguese basically said, 'We're not going to do that', and they went upmarket instead," said Legrain, the author of "European Spring: Why our Economies and Politics are in a Mess", which is published on April 24. "They are now selling more expensive designer shoes and their exports are soaring - wages and employment have risen," he said. "That shows in a nutshell how policy was misguided." The worst of Europe's debt crisis may have passed after four years of turmoil. But Legrain's book makes for withering reading, suggesting that by misunderstanding the problem, EU leaders and policymakers are responsible for the record-high unemployment and rock-bottom growth afflicting the union. Instead of recognising that the crisis was principally the fault of a banking sector run amok, leaders focused on the excessive debts of Greece, Ireland and Portugal - effectively seeing the problem as fiscal rather than financial. That led policymakers to enforce a strict regimen of budget cuts, tax increases and lower wages in an effort to improve competitiveness and make exports comparatively cheaper. "A crisis that could have been a unifying force - Europe acting together to tackle overmighty, dysfunctional cross-border banks - has instead become a divisive one, pitting creditors against debtors," Legrain writes. "Across Europe, fifteen million people below the age of thirty are neither in employment nor education. A lost Generation is in the making." OUTLOOK REMAINS DIM While Legrain acknowledges that Greece, with debts greater than its GDP and a budget deficit of 6.5 percent of output in 2008, was facing mainly a debt crisis rather than a banking one, he says the solution chosen by Europe was wrong. Rather than renegotiating or writing down much of that debt, the Commission, the International Monetary Fund and the European Central Bank pushed through two hard-to-swallow bailout programmes totalling more than 200 billion euros (164 billion pounds) that left Greece's economy shattered and just as indebted. Unemployment now stands at 26 percent and debt is expected to peak at 170 percent of GDP. Social unrest is bubbling. "Greece's debts should have been restructured in May 2010," said Legrain. "Instead, we have had a lurch towards self-defeating austerity and now have much more centralised fiscal controls, which are inflexible and undermine democracy." EU officials point out that while the rescue programmes applied to Greece, Portugal, Ireland and Cyprus were strict and tightly administered, they have succeeded in stabilising the crisis and all four countries are starting to recover. Ireland has successfully exited its programme and Portugal is scheduled to do so in the coming months. Cyprus is on track with its targets and Greece is running a much healthier than expected primary budget surplus. Legrain, who has previously written books about the benefits of globalisation and the need for more open immigration, counters that Europe would have bounced back more quickly if the right diagnosis had been made in the first place. It would also be further along in resolving deep-seated problems in its banking sector, while not having tied itself down with unbending fiscal rules and a single currency many now perceive as a "sadomasochistic straitjacket". A pro-European and former chief economist of Britain in Europe, Legrain is nonetheless downbeat about the prospects for the EU unless it takes radical steps to raise productivity and make itself more democratically accountable. He is particularly concerned about the survival of the single currency. "The EU will survive, but I think the euro zone might ultimately break up," he said. "My base line scenario is that the euro zone is headed for a Japanese-style period of stagnation and deflation." (Editing by Michael Roddy and Mark Heinrich)