[Viewpoint] Austere growth?

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[Viewpoint] Austere growth?

The German government’s reaction to newly elected French President François Hollande’s call for more growth-oriented policies was to say that there should be no change in the euro zone’s austerity programs. Rather, growth-supporting measures, such as more lending by the European Investment Bank or issuance of jointly guaranteed project bonds to finance specific investments, could be “added” to these programs.

Many inside and outside of Germany declare that both austerity and more growth are needed, and that more emphasis on growth does not mean any decrease in austerity. The drama of the ongoing euro zone crisis has focused attention on Europe, but how the austerity-growth debate plays out there is more broadly relevant, including for the United States.

Three essential points need to be established. First, in a situation of widespread unemployment and excess capacity, short-run output is determined primarily by demand, not supply. In the euro zone’s member countries, only fiscal policy is possible at the national level, because the European Central Bank controls monetary policy. So, yes, more immediate growth does require slower reduction in fiscal deficits.

The only counterargument is that slower fiscal adjustment would further reduce confidence and thereby defeat the purpose by resulting in lower private spending. This might be true if a country were to declare that it was basically giving up on fiscal consolidation plans and the international support associated with it, but it is highly unlikely if a country decides to lengthen the period of fiscal adjustment in consultation with supporting institutions such as the International Monetary Fund.

Without greater short-term support for effective demand, many countries in crisis could face a downward spiral of spending cuts, reduced output, higher unemployment and even greater deficits, owing to an increase in safety-net expenditures and a decline in tax revenues associated with falling output and employment.

Second, it is possible, though not easy, to choose fiscal-consolidation packages that are more growth-friendly than others. There is the obvious distinction between investment spending and current expenditure, which Italian Prime Minister Mario Monti has emphasized.

Last but not least, there are longer-term structural reforms, such as labor-market reforms that increase flexibility without leading to large-scale lay-offs (a model rather successfully implemented by Germany). Similarly, retirement and pension reforms can increase long-term fiscal sustainability without generating social conflict. A healthy older person may well appreciate part-time work if it comes with flexibility.

Finally, particularly in Europe, where countries are closely linked by trade, a coordinated strategy that allows more time for fiscal consolidation and formulates growth-friendly policies would yield substantial benefits compared to individual countries’ strategies, owing to positive spillovers (and avoidance of stigmatization of particular countries). But insufficient and sometimes counterproductive actions, coupled with panic and overreaction in financial markets, have brought some countries, such as Spain, which is a fundamentally solvent and strong economy, to the edge of the precipice, and with it the whole euro zone. In the immediate short run, nothing makes sense, not even a perfectly good public-investment project, or recapitalization of a bank, if the government has to borrow at interest rates of 6 percent or more to finance it.

These interest rates must be brought down through ECB purchases of government bonds on the secondary market until low-enough announced target levels for borrowing costs are reached, and/or by the use of European Stability Mechanism resources.
Such an approach would provide the breathing space needed to restore confidence and implement reforms in an atmosphere of moderate optimism rather than despair.

No catastrophic earthquake or tsunami has destroyed southern Europe’s productive capacity. What we are witnessing — and what is now affecting the whole world — is a man-made disaster that can be stopped and reversed by a coordinated policy response.

*The author, a former minister of economics in Turkey, is vice president of the Brookings Institution.

Copyright: Project-Syndicate, 2012

by Kemal Dervis
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