What trade unions across Europe have been warning against is now happening: far from bringing public finances under control, the strategy of European wide austerity is pushing the economy back into recession. While the European Commission, in its latest spring forecast, tries to give this a positive spin by talking of a ‘mild’ recession with a ‘slow’ recovery supposedly just around the corner, this is simply not correct. In large Euro Area member states in particular, such as Spain and Italy, the 2012 recession is painful with the economy shrinking by respectively 2 and 1.5%.
The ‘austerians’, facing this inconvenient reality, are now slightly adapting their position. They are now arguing that austerity did not work, not because it was wrong to cut deficits in the face of a weak recovery, but because the strategy was incomplete. Fiscal austerity should have been ‘complemented’ with some action on the side of growth with some growth-generating action. Policy proposals to this effect, such as mobilizing currently unused European structural funds and inserting new capital into the European Investment Bank so that it can finance major European investment projects, are already circulating. The end result of this ‘new’ approach, which we can call an “Austerity Plus” plan, is that fiscal consolidation is to be continued if accompanied with the type of policy actions described above. In this way, neither the principle of fiscal cuts nor the new Fiscal Compact treaty are put into question, not even in the face of mounting evidence of the economic and social disaster that brutal austerity is producing.
Can we have austerity and growth at the same time? One key reason to be skeptical is that the equation as proposed by the ‘austerians’ does not add up. The policy action on growth which some European policy makers are now proposing is simply too limited to be able to compensate for the negative effect of fiscal contraction. Take the example of Spain. According to official targets, Spain will be forced to cut its deficit from 8.9% of GDP (2011) to 5.3% in 2012 and 3% the year after. However, to realize an ex post 6% cut in the deficit over a two year period, thereby taking into account the impact on growth and second round negative effects on the deficit, Spain will need to do an ex ante fiscal cut that is almost double that amount and close to 12% of GDP. It does not take a highly trained econometrician to understand that this will push the Spanish economy into several years of recession, in exactly the same way as it did with Greece.
Now let’s suppose that the ‘austerians’ come through on their promises and provide, through the European Investment Bank, additional finance for projects and funds backing up demand and growth in the Spanish economy. Let’s also suppose that this doubles the amount of investment projects Spain has accessed in 2011 through EIB finance. This amounts to 17 billion euros, representing around 1.5% of Spanish GDP. However, even if such an injection in the Spanish economy is highly welcome, it will offset only a small part of the total 6 to 12% contractionary shock that would be administered to Spain in the course of the next two years. A similar calculation can be made for France, where the objective is to cut the deficit from 5.2% of GDP in 2011 to 3% by 2013. This boils down to an ex ante fiscal adjustment of 4% of GDP.
Moreover, the ambition does not stop with the 3% deficit target. After 2013, the idea is to rapidly eliminate budget deficits altogether along with planning a systematic fall in public debt ratios as described in the Fiscal Compact. Massive cuts in public budgets are therefore to continue beyond 2013. Unless entirely unrealistic proportions are assumed, there is no way a European investment program can deal with this.
Instead of trying to give credibility to a strategy that is simply non-credible, this week’s informal European Council should decisively go for a ‘Growth Plus’ plan. Europe needs to break with fiscal austerity and turn things upside down by starting to work from the growth side of the equation. Here’s how such a ‘Growth Plus’ plan works:
First, the focus of policy action needs to be shifted towards growth and away from austerity cuts. To do so, the proposals now being launched on European wide investments mainly supporting the ‘deficit’ countries together with EIB finance are a good basis to start from. At the same time, this must be accompanied by a temporary moratorium on new fiscal consolidation measures. To give growth and recovery a chance at least one a year of ‘fiscal healing’ is in order.
Once the economy reconnects with growth, then (and only then!), the public finance side of things is to be taken into account. However, this is not to be done by imposing brutal fiscal consolidation programs but by letting growth dynamics do their work. If, as we can witness from the renewed recession, austerity is self defeating, then the opposite is also true: growth and investment is self rewarding. By putting the economy back on the track of growth, public deficits will fall automatically. Even better, public debt ratios will also start falling because of the combined positive effect of a falling nominator (deficits) and a rising denominator (nominal GDP). However, it also needs to be understood that “self rewarding” growth is not a sprint but more like a marathon: it is a process that takes time and that needs to be given that time. This implies that the objectives of reaching a 3% deficit by 2013 or a zero deficit by 2016 or 2017 need to be spread over a longer period of time, unless (but we do not expect that to happen) the economy starts booming.
However, this still isn’t a ‘free lunch’. In fact, such a process of gradual and growth driven reduction of deficits does imply continued fiscal discipline. The benefits of growth need to be managed. Member states need to be prevented from squandering away the positive effect growth has on deficits and debt by, for example, engaging in another round of supply side/competitive tax cutting. In other words, deficit targets are to remain a firm part of European economic governance, provided they are flexible and adapted to the position of the economy in the business cycle.
If the Heads of Government are really serious about addressing the many problems Europe is facing, the European Council should stop ‘kicking the can down the road’ by making cosmetic changes to its austerity strategy and instead go for the ‘Growth Plus’ plan described above. If not now, then when?