[Viewpoint] Austerity in the euro zone

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[Viewpoint] Austerity in the euro zone

In June, it was Greece. In August, it was France, Italy, Spain and Portugal. In September, it was Greece again - and Spain. In November, France took another turn, before Italy again in December, this time in a major way. Every month, despite an ever-darker outlook for economic growth, countries announce new spending cuts and tax hikes in the hope of restoring confidence in the bond markets. Only Germany stands out, having recently announced a tax cut, albeit a modest one.

In other words, while all indicators point to a severe economic downturn in Europe, the euro zone’s current interest-rate spreads are provoking a shift to austerity. It looks like a no-brainer: accelerated budget cuts are preferable to a lethal interest-rate surge on public debt, even if the cuts increase the risk of recession. But there are caveats.

First, while indiscriminate austerity may be the only option for those euro zone countries that no longer have access to capital markets, others have more choice of policy options. Consolidation is required, but governments are responsible for its speed and its design.

Second, a sound fiscal strategy requires establishing, on the basis of prudent economic assumptions, an ambitious budgetary target for the medium term, determining what mix of taxation and expenditure cuts are required in order to achieve it, and then sticking to the plan throughout economic fluctuations. This allows the “automatic stabilizers” - lower receipts in a slowdown, higher in a boom - to come into play, preventing the economy from overheating at the top of the business cycle and providing stimulus at the bottom.

Third, headlong consolidation is not always the best way to reassure markets, which may worry more about growth. Italy is a case in point. The country’s budget deficit this year, at 4 percent of GDP, is far below that of Spain or France. Nibbling at the edges of a deficit is a sideshow.

Fourth, the cost of rushed austerity is that it generally relies on immediate fixes, such as indiscriminate spending cuts and tax hikes that are expected to yield revenue in the short term, but that have an economically damaging impact.

What should governments be doing? Fiscal consolidation is unavoidable, but that is a medium-term process. Instead of undertaking knee-jerk cuts, governments must first re-establish their credibility through policy rules enshrined in national legislations, as recently decided by the European heads of state and government.

Second, they should design and implement smart consolidations, even if they take a little more time to design and a little more time to implement. Doing so will take time, thought, and an iron will.

Copyright: Project Syndicate, 2011.


*The writer is director of Bruegel, an international economics think tank.

by Jean Pisani-Ferry
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