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Once again Europe’s efforts to contain its crisis have fallen short. It was perhaps reasonable to hope that the European Central Bank’s longer-term refinancing operation to provide nearly $1tn in cheap three-year funding to European banks would halt the crisis for a while if not resolve it. It is now clear it has been 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 see banks grow ever more nervous. Again, both Europe and the global economy approach the brink.
In any policy sphere a great debate always follows signs of failure. The architects of the current policy and their allies argue that the problem lies in insufficient determination to maintain the existing strategy. Others argue for a change in course, a view that seems to be taking hold among European electorates – and rightly so. There is a good chance that much of what is being urged is likely to be not just ineffective but counterproductive in terms of maintaining the monetary union, restoring normal financial conditions and government access to markets, and re-establishing 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. So, the strategy is one of providing financing while insisting on austerity. The hope is 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 programmes in emerging markets and Germany’s successful adjustment after the expense of reintegrating the east.
Unfortunately, Europe has misdiagnosed its problems and set the wrong strategic course. Outside Greece, which represents only 2 per cent of the eurozone, 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. Italy had a high debt ratio but a very favourable 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.
Treating symptoms rather than causes is usually a good way to make a patient worse. So it is in Europe. Its financial problems stem from 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 context increased austerity is a step in the wrong direction.
Systematic comparisons of the experience of different European countries or more global comparisons at the IMF are salutary. They suggest that, when economies are constrained by demand 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. This implies a 1 per cent reduction in a country’s ratio of spending to GDP or an equivalent tax increase reduces its GDP growth rate by 1 to 1.5 per cent.
This means 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 very limited reductions in deficits once the adverse effects of contraction on tax revenues and benefit payments are taken into account. And it casts a shadow over future growth prospects by reducing capital investment and raising unemployment, which takes a toll on the capacity and willingness of the unemployed to work.
These considerations are magnified in Europe as a whole. Slowdowns in one country reduce demand for the exports of others. Increases in saving and exporting in some countries have to be offset by equal 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 reducing its borrowing substantially unless Germany pursues policies that allow its surplus to contract.
Sceptics 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 an individual and by a country. Normally, an individual helps his creditors by borrowing less, but a person who stops borrowing to finance commuting to work does his creditors no favour. Similarly, since for a country income is determined by spending, a country that pursues austerity to the point where its economy is driven into a downward spiral does its creditors no favour. Yes, there will ultimately be a need to raise retirement ages, reform sclerosis-inducing regulations and restructure benefit programmes. Phased in, commitments in these areas would be constructive. But the prospect for success, politically and economically depends on the restoration of growth.
Only in this context is it credible to imagine the euro enduring and European financial problems being successfully resolved. If there were ever a situation that called for a collective solution it is this one. Looking ahead, the IMF and the international community should make further support conditional not merely on the actions of individual states, but on a common European commitment to growth.
The writer is a former Treasury secretary and Charles W. Eliot professor at Harvard University