Europe, End the Austerity Mania

A scary economic policy debate is haunting Europe these days. The Germans seem to believe that “If only everyone were more like us, the world would be in better shape.”

Governments would no longer go on spending sprees they can ill afford, the argument continues. By virtue of creating an environment in which growth and employment can flourish while prices rise at a reasonable pace, the economic crisis would be over.

When German policymakers look at Europe, they only see that the list of those who need to take in German policy prescriptions has changed. The sinners of the past – Spain, Portugal, Greece and Ireland – have left the worst behind them.

Now, EU “big shots” Italy and France are in the hot seat, facing growing pressure to get their economies in order.

In this ever-present debate, we should get one thing straight. While the single-minded focus on austerity is understandable politically, it is no panacea. Of course, who wouldn’t want a balanced budget?

But the goal of a balanced budget is, put bluntly, nonsense from an economic perspective. It represents one of the many fallacies and prejudices that shape today’s European policymaking.

Austerity not a cure all

The hypothesis that austerity is the cure all has been proven wrong empirically. The countries that didn’t follow this maxim have actually not fared worse economically. By the same token, those who did are not better off today.

Take Spain, for example. Over the past decade, the country has been a prime example of fiscal virtue. But its economy nonetheless slipped badly during the debt crisis. Now, Spain is bound for a recovery — even though it has done little in the way of fiscal consolidation. The Spanish budget deficit still exceeds 5% of GDP.

Conversely, Germany has managed to balance its budget over the past years. But now the much-lauded German growth engine is stalling. And this development cannot be blamed on trade sanctions against Russia alone. It is also a matter of setting the wrong economic policy priorities.

Preoccupied with fiscal policy performance, Germany has lost sight of other pressing problems. Ever since the “Hartz IV” labor market reforms a decade ago, there has been a conspicuous absence of undertaking structural reforms. In other words, Germany failed to apply the medicine to itself that it so ardently wants others to take.

Even worse, previous, sensible structural reforms (such as gradually increasing the retirement age) were partially rolled back again. Not surprisingly, Germany ranks near the bottom in terms of responsiveness to OECD policy recommendations – far behind the Southern European countries.

Empirical evidence aside, the austerity hypothesis is also theoretically flawed. Economic growth and competitiveness are not determined by fiscal discipline.

What really counts is that businesses can be vibrant and innovative, stimulated by a high degree of flexibility and competition in the goods and labor markets. Only if these conditions are met can the economy grow, can new workers be hired and supply be adjusted efficiently to changing demands.

Austerity’s indirect effects

Do we need austerity at all then? Yes, but mainly for its indirect, Ricardian effects. Austerity sends a signal that a government is willing to get its act together. Sound fiscal policy sets an example for private enterprise and builds trust. Firms tend to perform better if they do not need to expect any unpleasant surprises on the tax front.

Likewise, international investors prefer to spend their money in a country that knows how to handle its economy. This, in turn, will lead to lower interest rates.

Governments that are sloppy in fiscal matters can hardly be trusted to undertake much-needed structural reforms. The latter, after all, usually incur even more political resistance than mere spending cuts.

Structural reforms must take priority

Fiscal consolidation thus plays an important role. But it is no silver bullet and should not dominate the economic policy agenda. Structural reforms must be the top priority. They must come first — before any major efforts are undertaken to get the budget back on track.

If France and Italy prove they are serious about implementing far-reaching structural reforms, they should be given more time for fiscal consolidation.

However, if the reform plans are limited to rectifying near absurdities like the 35-hour workweek, as France is currently contemplating, then adding fiscal discipline won’t lead to a change for the better. Giving countries more fiscal flexibility, in the mere expectation of structural reforms, will likely turn things for the worse.

Some go as far as saying that fiscal consolidation has a negative impact on economic growth because it reduces aggregate demand. This, too, is oversimplifying. Of course, a government would cut spending or absorb purchasing power.

But fiscal consolidation also has a positive influence on the business climate that will stimulate demand. As economic theorists put it, the negative Keynesian effect goes along with a positive Ricardian effect.