Austere Growth?

The German government’s reaction to newly elected French President François Hollande’s call for more growth-oriented policies was to say that there should be no change in the eurozone’s austerity programs. Rather, growth-supporting measures, such as more lending by the European Investment Bank or issuance of jointly guaranteed project bonds to finance specific investments, could be “added” to these programs.

Many inside and outside of Germany declare that both austerity and more growth are needed, and that more emphasis on growth does not mean any decrease in austerity. The drama of the ongoing eurozone crisis has focused attention on Europe, but how the austerity-growth debate plays out there is more broadly relevant, including for the United States.

Three essential points need to be established. First, in a situation of widespread unemployment and excess capacity, short-run output is determined primarily by demand, not supply. In the eurozone’s member countries, only fiscal policy is possible at the national level, because the European Central Bank controls monetary policy. So, yes, more immediate growth does require slower reduction in fiscal deficits.

The only counterargument is that slower fiscal adjustment would further reduce confidence and thereby defeat the purpose by resulting in lower private spending. This might be true if a country were to declare that it was basically giving up on fiscal consolidation plans and the international support associated with it, but it is highly unlikely if a country decides to lengthen the period of fiscal adjustment in consultation with supporting institutions such as the International Monetary Fund. Indeed, the IMF explicitly recommended slower fiscal consolidation for Spain in its 2012 World Economic Outlook.

Without greater short-term support for effective demand, many countries in crisis could face a downward spiral of spending cuts, reduced output, higher unemployment, and even greater deficits, owing to an increase in safety-net expenditures and a decline in tax revenues associated with falling output and employment.

Second, it is possible, though not easy, to choose fiscal-consolidation packages that are more growth-friendly than others. There is the obvious distinction between investment spending and current expenditure, which Italian Prime Minister Mario Monti has emphasized. The former, if well designed, can lay the foundations for longer-term growth.

There is also the distinction between government spending with high multiplier effects, such as support to lower-income groups with a high propensity to spend, and tax reductions for the rich, a substantial portion of which would likely be saved.

Last but not least, there are longer-term structural reforms, such as labor-market reforms that increase flexibility without leading to large-scale lay-offs (a model rather successfully implemented by Germany). Similarly, retirement and pension reforms can increase long-term fiscal sustainability without generating social conflict. A healthy older person may well appreciate part-time work if it comes with flexibility. The task is to integrate such work into the overall functioning of the labor market with the help of appropriate regulation and incentives. 

Finally, particularly in Europe, where countries are closely linked by trade, a coordinated strategy that allows more time for fiscal consolidation and formulates growth-friendly policies would yield substantial benefits compared to individual countries’ strategies, owing to positive spillovers (and avoidance of stigmatization of particular countries). There should be a European growth strategy, rather than Spanish, Italian, or Irish strategies. Countries like Germany that are running a current-account surplus would also help themselves by helping to stimulate the European economy as a whole.

Slower fiscal retrenchment, space for investment in government budgets, growth-friendly fiscal packages, and coordination of national policies with critical contributions from surplus countries can go a long way in helping Europe to overcome its crisis in the medium term. Unfortunately, Greece has become a special case, one that requires focused and specific treatment, most probably involving another round of public-debt forgiveness.

But insufficient and sometimes counterproductive actions, coupled with panic and overreaction in financial markets, have brought some countries, such as Spain, which is a fundamentally solvent and strong economy, to the edge of the precipice, and with it the whole eurozone. In the immediate short run, nothing makes sense, not even a perfectly good public-investment project, or recapitalization of a bank, if the government has to borrow at interest rates of 6% or more to finance it.

These interest rates must be brought down through ECB purchases of government bonds on the secondary market until low-enough announced target levels for borrowing costs are reached, and/or by the use of European Stability Mechanism resources. The best solution would be to reinforce the effectiveness of both channels by using both – and by doing so immediately.

Such an approach would provide the breathing space needed to restore confidence and implement reforms in an atmosphere of moderate optimism rather than despair. The risk of inaction or inappropriate action has reached enormous proportions.

No catastrophic earthquake or tsunami has destroyed southern Europe’s productive capacity. What we are witnessing – and what is now affecting the whole world – is a man-made disaster that can be stopped and reversed by a coordinated policy response.