Euro’s survival needs shift in strategy

Rather than the austerity prescription Germany is promoting, the euro needs policies to promote growth and ease deficit targets to avoid sustained recession, writes Laura Tyson

FISCAL profligacy did not cause the sovereign-debt crisis engulfing Europe, and fiscal austerity will not solve it.

On the contrary, such austerity has aggravated the crisis and threatensto bring down the euro and throw the global economy into another tailspin.

In 2007, Spain and Ireland were models of fiscal rectitude, with far lower debt-to-GDP ratios than Germany. Investors were not worried about default risk on Spanish or Irish sovereign debt, or about Italy’s chronically large sovereign debt. Indeed, Italy boasted the lowest deficit-to- GDP ratio in the eurozone, and the Italian government had no problem refinancing at attractive interest rates. Even Greece, despite its eroding competitiveness and increasingly unsustainable fiscal path, could attract capital.

Deluded by the convergence of bond yields that followed the euro’s launch, investors fed a decade-long private-sector credit boom in Europe’s less-developed periphery countries, and failed to recognise property bubbles in Spain and Ireland, or Greece’s slide into insolvency. When growth slowed sharply and credit flows collapsed in the wake of the Great Recession, budget revenues plummeted, governments were forced to socialise private-sector liabilities, and fiscal deficits and debt soared.

Except with Greece, the deterioration in public finances was a symptom of the crisis, not its cause. Moreover, the deterioration was predictable: History shows that the real stock of government debt explodes in the wake of recessions caused by financial crises.

Overlooking the evidence, European leaders, spearheaded by Germany, misdiagnosed the problem as one of fiscal profligacy for which painful austerity was the only cure. On this view, significant and rapid reductions in government deficits and debt are a precondition to restoring government credibility and investor confidence, stemming contagion, lowering interest rates, and reviving economic growth.

There is also a moral-hazard aspect to the austerity argument: Easing repayment terms for spendthrift governments will only encourage reckless behaviour in the future. Moreover, virtuous creditors should not bail out irresponsible borrowers, be they private or public. From this perspective, austerity is the necessary and just penance for reprobates such as Greece, Spain, and Italy.

But austerity is not working; indeed, it is counterproductive. In the short to medium term, fiscal consolidation — whether in the form of cutting government spending or increasing revenues — results in lower output and employment, which means lower tax collection, higher deficits, and escalating debt relative to GDP.

Savvy investors, like frustrated voters, recognise that low growth and high unemployment enlarge deficits and add to debt in the short run. That is why, after more than two years, interest rates are rising, not falling, in countries crushed by onerous austerity measures.

In fact, there is no simple relationship between the size of a government’s deficit or debt and the interest rate that it must pay. British government bonds now offer significantly lower interest rates than those of France, Italy, or Spain, even though Britain’s fiscal position is considerably worse.

Greece is caught in a classic debt trap, as the interest rate on its public debt has soared beyond its growth rate by a considerable margin. Spain is teetering on the brink. Austerity in Europe has confirmed the IMF’s warning that overdoing fiscal consolidation weakens economic activity, undermines market confidence, and diminishes popular support for adjustment.

In the long run, many eurozone countries, including Germany, require fiscal consolidation in order to stabilise and reduce their debt-to-GDP ratios. But the process should be gradual and back-loaded — with much of the consolidation coming after Europe’s economies return to a sustainable growth path.

Structural reforms are also necessary in most European economies to bolster competitiveness and boost potential growth. But such reforms take time: German chancellor Angela Merkel appears to have forgotten that it took more than a decade and roughly €2,000bn in subsidies for structural reforms to make the former East Germany competitive with the rest of the country.

Italian prime minister Mario Monti and French president François Hollande are right: Europe needs bold, coordinated policies to promote growth, along with market-based structural reforms to foster competition and an easing of fiscal targets until output and employment recover.

But how can significant new growth initiatives be financed? The reality is that the rest of Europe cannot succeed in restoring growth without Germany, and Germany is wedded to the austerity cure.

With a modest fiscal deficit, record-low borrowing costs, and a huge current-account surplus, Germany has the financial firepower to unleash a significant stimulus. But Germany sees no need to stimulate its own economy and is willing to consider only modest eurozone measures, such as additional capital for the European Investment Bank, a small pilot programme for EU “project bonds” for infrastructure investment, and more rapid deployment of unspent EU structural funds.

Germany refuses even to allow spending on high-priority infrastructure projects to be exempted from the unrealistic deficit targets set by the EU’s new fiscal treaty.

Despite pleas from the IMF and the OECD, Germany also remains implacably opposed to eurobonds, which could ease the funding constraints of other eurozone members and bolster the resources of the European Stability Mechanism, which currently does not provide a credible firewall against a run on Spanish or Italian sovereign debt — or on the European banks that hold it. Indeed, the worsening banking crisis, with deposits fleeing from the eurozone periphery, is further strangling Europe’s growth prospects.

It is probably too late to save Greece. But a shift toward policies to promote growth, supported by the easing of deficit targets and the issuance of eurobonds, is essential to bring Europe back from the brink of sustained recession, to stabilise Europe’s financial markets, and to prevent another significant disruption to global capital markets.

* Laura Tyson is a professor at the Haas School of Business at the University of California, Berkeley. Copyright: Project Syndicate, 2012

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