Europe Renews Austerity Fight

May 14, 2013 Topic: Economics Region: Europe

Europe Renews Austerity Fight

A number of key voices are pushing for relaxed finances and slower structural shifts.

Copy-hungry journalists must love Europe. It seems to approach each phase of this ongoing crisis with wholly new solutions. For those who write on it, this evolution demands a series of new explanations and invites renewed speculations at each turn. But for investors and business people, it is less welcome. It makes planning next to impossible. And because planning is essential for financial stability and economic expansion, the continent’s economy and financial markets would benefit from something that is perhaps less exciting to write about—and more definite and predictable.

In this latest turn, eurozone members seem to have developed new doubts about fiscal austerity. A tenuous consensus had formed around the need for budget restraint and deficit reduction, but now some look to moderate the severity of the program, while others would reverse policy altogether. This new turn, disruptive as it is, does have virtues. It would, after all, lift the threat of a vicious downward economic cycle in which austerity depresses economic activity that causes worse deficits that only invite more austerity. But at the same time, the shift in fiscal emphasis carries its own ills. For one, it threatens to bring the continent back to its old profligate ways. Even worse, this new turn from austerity seems to have distracted policy makers from their former embrace of structural reforms and the promise they made to ease the continent’s fundamental fiscal-financial woes.

The austerity consensus never had complete support. French president Francois Hollande ran for office last year on a platform of fiscal relaxation. Because the preference for austerity was still dominant at the time, he glossed specifics enough to allow voters to see him simultaneously as both for and against austerity. But the signs were there. If Hollande signaled an early warning, the first major cracks in the austerity consensus became fully evident in Italy’s February election. The electorate there, enraged by the economy’s decline, returned an inconclusive vote that clearly threatened the fiscal and regulatory reforms set in motion by the outgoing prime minister, Mario Monti. For a while, Italy could not even form a government. When, recently, it did, the new prime minister, Enrico Letta, was clearly constrained. Though his Democratic Party had endorsed the previous fiscal program, he could only hold power by making concessions to the contrary positions of his powerful opposition.

Since then, policy fissures have grown even wider. Hollande has seized on the changing environment to climb off the fence he had made for himself. He has reneged on his a former promise to bring the budget deficit down to 3 percent of the nation’s gross domestic product (GDP) this year and now talks of a target closer to 4 percent. Spanish prime minister Mariano Rajoy, having endorsed rigid austerity for the entire sixteen months since his election, has recently outlined new policies that would allow less pressing deficit targets. Portugal has followed suit. In just the last couple of months, the Lisbon government has decided to pursue fiscal stimulus, including corporate tax cuts. It has promised to bring its budget deficit, presently at 6.4 percent of GDP, down to the promised 3 percent by 2015, but many question the prospect given the government’s new policy posture. Italy’s prime minister, Letta, though he recently announced in Berlin that he would continue ongoing budget rigor, had already softened policy, proposing, almost on taking office, to cut taxes on sales and property and widen Italy’s welfare net, including jobless benefits.

European Commission president José Manuel Barroso explained the change in tone. He told the media bluntly that austerity had “reached its limits,” having lost the public support it needed to work. He, too, now wants more latitude for countries to run deficits wider than 3 percent of GDP. Even the International Monetary Fund (IMF) has changed. Having long promoted strict budget discipline, in just the last month or so Managing Director Christine Lagard has begun to question the value of such a harsh policy. Also acknowledging the change is European Commission economic chief, Olli Rehn. He has embraced a “smoother pace to fiscal consolidation,” telling the United States and others arguing against austerity: “Can I tell you a secret? We have already slowed down fiscal consolidation.” Of course, Greece and Cyprus, desperate for aid from the rest of the eurozone and the IMF and bound by past agreements, continue austerity measures, but the cracks in the former consensus are apparent.

On the positive side, this new tone does relieve some of the downside risk implicit in strict austerity. Because severe budget restraint slows and often halts economic activity, it also stems the flow of tax revenues while it increases demands for government services, such as unemployment relief and welfare. If severe enough, the net effect can enlarge budget deficits, even as governments increase taxes and trim government spending. But since a single-minded austerity approach only then demands more restraint, it can set an economy into a vicious cycle of decline in which austerity creates recession that only evokes more austerity. Part of the recent policy change no doubt reflects fears that just such a cycle is developing. After all, business activity has fallen steeply across Europe and especially in those countries that have pursued the most aggressive austerity programs. Unemployment has risen to 26.7 percent of the workforce in Spain, for instance, 25.7 percent in France, 17.5 percent in Portugal, more in Greece, and 12.1 percent for the eurozone as a whole.

But if the policy rethink helps alleviate such risks, it carries problems of its own. One is obvious. Europe does really need budgetary reform. The profligate fiscal policies of the past were clearly unsustainable. A realization of that fact brought on this crisis in the first place, when lenders refused to advance more credit to the continent’s periphery. Approaching fiscal sanity along a gentler, less demanding path might seem reasonable in the face of Europe’s present intense economic pain, but the best these nations practically can do is reduce the intensity of restraint. Were they to go any further to, say, something openly stimulative, they might relieve the symptoms of economic illness for a time, but the relief would run its course very quickly. Soon, the renewed profligacy would prompt lenders again to withhold credit, shutting down these economies even more brutally than a regime of austerity would.

The policy turn carries political risks as well. Germany has an election in September. Many Germans still resist their country’s prominent role in the financial rescues. Chancellor Angela Merkel has until now placated these elements by insisting on budget austerity as a quid pro quo for the aid. But the fiscal softening in France, Italy, and elsewhere will likely fortify this internal opposition to Merkel’s approach. They will ask, not without justice, why German taxpayers should bear such burdens when Italians, Spaniards, and others who benefit from the funds refuse to cooperate fully.

The fear of throwing good money after bad might have an answer in a gentler path to budgetary reform, but such fine points could easily get lost in the cut and thrust of the election campaign, especially since polls show German citizens very concerned about the use of their taxes. Those same polls do also show little support for a German departure from eurozone, and they show Merkel still popular enough to retain her office. But if the opposition can gain enough ground to limit her ability to help Europe, credit markets will almost surely become less responsive to eurozone reassurances about its weaker members.

The biggest problem with this changing tone, however, is that it seems to have distracted policy makers from the important structural reforms on which they had embarked. These started in Italy under Monti. He understood the downside risks of a single-minded focus on austerity, however necessary budget reform was. Impressed by the success of German labor market and regulatory reforms under former chancellor Gerhard Schröder, he pushed a similar agenda in Italy as a growth antidote to the depressing effects of austerity. He also saw structural reform as a way to improve the economy’s underlying growth potential and so offer a fundamental answer to the country’s fiscal-financial dilemma. He made remarkable strides easing Italy’s rigid labor regulations, allowing firms more flexibility on hiring, firing and work rules. He was looking to product regulatory reform, as well as additional labor-market reforms, when he exited office. Seeing his reasoning and his progress, Spain, Greece, Portugal and others in Europe’s troubled periphery also began to make similar changes. But in this latest discussion of easing the severity of budget restraint, such structural reform efforts seem to have taken a back seat.

To be sure, European leaders still pay lip service to such fundamental changes. Spain’s Mariano Rajoy alluded to “new structural reforms” when he announced less stringent deficit targets. Disappointingly, his comments lacked specifics. France’s Francois Hollande has overseen efforts to allow employers more flexibility and has spoken of renewed entrepreneurial effort. But his solutions have lacked breadth and, in fact, are a very limited, controlling and highly selective series of tax breaks. More troubling, he has said little about any such reform since he announced his eased deficit targets. The only strong French voice for structural change is that of Bank of France governor Christian Noyer, and he is outside the government.