Once again European efforts to contain crisis have fallen short. It was perhaps reasonable to hope that the European Central Bank’s commitment to provide nearly a trillion dollars in cheap three-year funding to banks would, if not resolve the crisis, contain it for a significant interval. Unfortunately, this has proved little more than a palliative.
Weak banks, especially in Spain, have bought more of the debt of their weak sovereigns, while foreigners have sold down their holdings. Markets, seeing banks holding the dubious debt of the sovereigns that stand behind them, grow ever nervous. Again, Europe and the global economy approach the brink.
The architects of current policy and their allies argue that there is insufficient determination to carry on with the existing strategy. Others argue that failure suggests the need for a change in course. The latter view seems to be taking hold among the European electorate.
This is appropriate. Much of what is being urged on and in Europe is likely to be not just ineffective but counterproductive to maintaining the monetary union, restoring normal financial conditions and government access to markets, and re-establishing economic growth.
The premise of European policy making is that countries are overindebted, and so unable to access markets on reasonable terms, and that the high interest rates associated with excessive debt hurt the financial system and inhibit growth. The strategy is to provide financing while insisting on austerity, in hopes that countries can rein in their excessive spending enough to restore credibility, bring down interest rates and restart economic growth. Models include successful International Monetary Fund programs in emerging markets and Germany’s adjustment after the expense and trauma of reintegrating East Germany.
Unfortunately, Europe has misdiagnosed its problems in important respects and set the wrong strategic course. Outside of Greece, which represents only 2 per cent of the euro zone, profligacy is not the root cause of problems. Spain and Ireland stood out for their low ratios of debt to gross domestic product five years ago, with ratios well below Germany’s. Italy had a high debt ratio but a very favorable deficit position. Europe’s problem countries are in trouble because the financial crisis under way since 2008 has damaged their financial systems and led to a collapse in growth. High deficits are much more a symptom than a cause of their problems. And treating symptoms rather than underlying causes is usually a good way to make a patient worse.
The cause of Europe’s financial problems is lack of growth. In any financial situation where interest rates far exceed growth rates, debt problems spiral out of control. The right focus for Europe is on growth; in this dimension, increased austerity is a step in the wrong direction.
Systematic comparisons suggest that when economies are demand-constrained and safe short-term interest rates are near zero, policy measures that reduce the deficit by 1 per cent have a multiplier of 1 to 1.5 - implying that a 1 per cent reduction in a country’s ratio of spending to GDP or an equivalent tax increase reduces its GDP by 1 to 1.5 per cent. Essentially, cutting deficits will have a disproportionately adverse effect on GDP because the multiplier is larger than 1 on the growth-reduction side of the equation. This means that austerity measures at the national level are likely to be counterproductive in terms of creditworthiness. Fiscal contraction reduces incomes, limiting the capacity to repay debts. It achieves only limited reductions in deficits once the adverse effects of economic contraction on tax revenue and benefit payments are accounted for. And it casts a shadow over future growth prospects by reducing capital investment and raising unemployment, which inevitably takes a toll on the capacity and willingness of the unemployed to work.
These considerations are magnified at the continental level. Slowdowns in one country reduce the demand for the exports of other countries. As a matter of arithmetic, increases in saving and exporting in some countries have to be offset by increases in spending and importing in others. Germany’s enormous success in recent years has been achieved by becoming a large-scale net exporter - it would not have been possible without large-scale borrowing and importing by Europe’s periphery. The periphery cannot possibly succeed in substantially reducing its borrowing unless Germany pursues policies that allow its surplus to contract.
Skeptics will rightly wonder how a prescription for more spending by countries that already have trouble borrowing can be correct. The answer lies in the difference between borrowing by individuals and countries. Normally, an individual helps his creditors by borrowing less; but a person who stops borrowing to finance commuting to his job does his creditors no favor. A country’s income is determined by spending, so a country that pursues austerity to the point where its economy is driven into a downward spiral does its creditors no favor. Yes, there will ultimately be a need to raise retirement ages, reform sclerosis-inducing regulations and restructure benefit programs; phased-in commitments in these areas would be constructive. But the prospect for political and economic success in these endeavors depends on growth being restored.
Only if growth is restored can the euro endure and European financial problems be resolved. If there was ever a situation that called for a collective response, this is it. Going forward, the IMF and international community should condition further support not merely on individual countries’ actions but on a common European commitment to growth.