This spring the need for growth policies to balance austerity was the talk of Brussels, Paris and even Frankfurt, home of the archconservative European Central Bank. But in recent weeks the babble of voices pushing the growth agenda has become more muted. Has the euro zone abandoned the search for growth on grounds of irreconcilable incompatibility with the imperative for austerity?
Increasing numbers of political and financial leaders argued as 2012 unfolded that a Spartan diet of cuts and nothing else was not enough to solve the euro zone debt crisis — because without measures to boost growth at the same time, cuts would simply send public finances into a deadly spiral of lower growth, lower tax revenue and the need for even more cuts. The growth party reached its high water mark when Mario Draghi, president of the ECB, called in April for a “growth compact.”
It was always going to be difficult to journey down the preferred road to growth of many European soft-left politicians and several eminent economists: the Keynesian approach of increasing government spending and cutting taxes to give a fiscal boost to overall demand. Since this policy is at direct odds with fiscal austerity, the most that could reasonably be done without frightening bond markets was to ease the pace of parsimony.
This was, in part, the approach of François Hollande, touted as the leader of the euro zone growth camp. During the campaign leading up to his election as French president in May, he accepted the need for austerity but called for a compromise — postponing the elimination of France’s fiscal deficit by a year to 2017, and relying more on growth to close that gap than had previous government plans. Mariano Rajoy, who became Spain’s prime minister in December, also tried to ease the pace of retrenchment — shocking the Brussels establishment by unilaterally easing the deficit target from 4.4 to 5.8 percent of gross domestic product without consulting EU economic and monetary affairs commissioner Olli Rehn, with whom the previous target had been agreed.
However, later events have made even these modest triumphs against austerity rather transitory. France’s national auditor, the Cour des Comptes, warned this month that the government needed to make “unprecedented” cuts in spending, as well as increasing taxes. “The budgetary equation will be more difficult than expected because of the worse economic situation,” said Didier Migaud, president of the Cour. Hollande is therefore under pressure to cut even more savagely than his predecessor Nicolas Sarkozy, rather than less so.
Rajoy was, meanwhile, rapidly forced by nervous bond market reaction to backtrack on his pledge, devising a compromise deficit target of 5.3 percent.
The only option left to growth champions is to pursue a course that combines growth and austerity, rather than choosing one over the other.
This is, in fact, what Draghi had in mind when he espoused the growth compact — arguing that structural reforms, including attempts to boost competitiveness, would aid economic expansion. Structural reforms have the virtue in the eyes of central bankers that they usually cost governments nothing in fiscal terms. Instead they frequently require the heavy expenditure of political capital — which is why, until austerity leaves them no choice, politicians tend instead to prefer the easier option of higher government spending to pump prime the economy.
Hollande has so far made little progress on structural reform. Indeed, some analysts complain that he is travelling in the opposite direction by announcing plans to make it harder for companies to lay off workers.
However, Rajoy has made some headway on reform. He has liberalized wage negotiations, for example, by encouraging a move away from sector-wide national deals to company-by-company arrangements based on what each business can afford — a measure that should incur zero cost to the government but should bolster employment in businesses unable to cope with national wage increases that take no account of their particular circumstance.
But the poster-child for structural reform is Draghi’s home country of Italy — whose achievement of this accolade has been eased by the fact that reform-minded politicians can choose from a staggering variety of indefensible and at times downright barmy restrictive practices.
A bevy of measures implemented by Mario Monti, the technocrat prime minister who came to power last year, includes opening closed professions such as pharmacists and notaries, cuts in red tape for small and mid-sized businesses, and efforts to reduce Italy’s high number of business-related court cases, which eat up management time and create corporate uncertainty.
The Organization for Economic Cooperation and Development has calculated that the full range of reforms will increase productivity by between 2 and 3 percent by 2020 — a significant boost to Italy’s GDP and tax revenue.
The International Monetary Fund welcomed Italy’s changes in a report on the country this month — praising “the important steps taken towards deregulating the service sector and making the labor market more flexible and inclusive.” However, it also warned of the need for further measures to “better match wages to productivity” through the kind of decentralization of pay bargaining, which Spain is implementing, and of the need to “reduce the cost of doing business”.
Italy is still likely to be a relatively low-growth country even if the OECD is right, because of the fiscal drag on output for years to come as Italy strives to reduce its debt burden — estimated by the International Monetary Fund to reach 126 percent of GDP this year.
The catch is that such policies take a long time to produce beneficial effects. Liberalization will eventually make pharmacists more efficient, by increasing competition — but it could take a generation for enough formerly frustrated pharmacists to enter the profession to make this happen.
Credit Suisse describes Monti’s reforms as “impressive”, but calculates that they will add only 0.7 percentage points to GDP by the end of 2014 — making a marginal difference in the short term to an economy, which shrank by more than that in the first quarter of 2012 alone.
In the long run structural reform may work, but the flaw is that it works more slowly than Keynesian demand management. Italy and other peripheral euro zone sovereign markets are likely to suffer further panics before structural reform bears economic and fiscal fruit. This suggests that as well as encouraging long-term changes to the structure of economies, Draghi also needs to be ready to support the bonds of reforming governments with hard cash.
