Originally published in *The Financial Times*
July 9, 2013
*An end to austerity will not boost Europe*
By MARTIN FELDSTEIN
The eurozone periphery is on a risky path to end fiscal austerity and
accept larger budget deficits. Portugal is the most recent dramatic shift
in that direction; Italy, Spain and even France are also abandoning plans
to cut spending and raise taxes.
This move away from budget discipline reflects a combination of popular
political pressure, more accommodating bond markets and encouragement from
the International Monetary Fund.
But ending fiscal austerity is not a strategy for achieving growth. It will
reduce downward pressure on aggregate spending but will not lift growth and
employment. Instead, it will raise interest rates and threaten a new fiscal
crisis.
Europe needs three things: structural changes to boost long-run potential
gross domestic product, a short-term stimulus to increase employment, and a
commitment to longer-term spending reductions to shrink the national debt.
The political pressure to end austerity is widespread. Italian voters
demanded relief from the higher taxes and the reduced pension benefits
previously introduced by the Monti government. In France, President
François Hollande won his election with a promise to end austerity and
recently rejected the European Commissions demands for specific budget
cuts. Spain and Portugal reacted to public riots by negotiating with
Brussels to delay deficit targets.
The high interest rates on sovereign bonds that put pressure on governments
to cut fiscal deficits fell sharply with the announcement last August by
Mario Draghi, president of the European Central Bank, of a central bank
Outright Monetary Transaction bond-buying facility. The pressure was
further reduced when IMF officials encouraged the shift away from budget
tightening.
The IMF staff responded by raising estimates of the fiscal deficits of
France and the peripheral countries. The increase in current budget
deficits and the expectation of higher future deficits have caused
long-term interest rates to begin rising in all of these countries. As
investors see fiscal deficits increase during the coming year, interest
rates are likely to rise further and faster.
The relatively moderate pace of the recent increase in sovereign interest
rates suggests that markets have forgotten the conditional nature of Mr
Draghis promise. The ECBs willingness to limit interest rates on
peripheral country bonds depends on each country having an approved fiscal
programme. With the countries shifting away from sound budgets, the ECB is
no longer committed to act and would be unwise to do so.
Rising interest rates could bring back the fiscal crisis of a mutually
reinforcing spiral of increasing national debts and rising borrowing costs.
That could revive the risk that some countries would be unable to borrow
and might therefore choose to leave the euro. If the ECB tried to prevent
that despite the lack of fiscal discipline, the result would be escalating
rates of inflation.
To prevent this, governments must combine long-run deficit reductions with
short-run fiscal stimulus. Slowing the growth of pensions and other
transfers would reduce future debt and prevent near-term increases in
interest rates. To make these changes politically acceptable, governments
should combine them with an immediate programme of infrastructure
investment and manpower training. This would not only raise current GDP but
would also strengthen long-run productivity and real incomes.
The slower growth of transfer programmes would also permit lower payroll
tax rates, cutting the cost of labour and increasing employment. Lower
labour cost would also raise the competitiveness of European products in
international markets.
A lower value of the euro could provide a further boost, making it possible
to lift employment while shrinking the short-term fiscal deficits. Although
a lower euro would not change the exchange rate within the eurozone,
countries outside the eurozone account for roughly 50 per cent of the
peripheral countries trade.
Policies to allow budget deficits to rise are a dangerous mistake. Italy,
France, Spain and Portugal should instead combine longer-term debt
reduction with short-term fiscal stimulus. Together with a slowing in the
growth in pensions and other transfers, this would boost productivity and
lower deficits and payroll taxes to the benefit of all Europeans. The
eurozone needs to adopt such policies.
Received on Tue Jul 09 2013 - 08:46:40 EDT
