Europe’s bargain

MILAN - In July, the European Commission published its sixth report on economic, social and territorial cohesion (a term that can be roughly translated as equality and inclusiveness). The report lays out a plan for substantial investment - 450 billion euros ($573 billion) from three European Union funds - from 2014 to 2020. Given today’s difficult economic and fiscal conditions, where public-sector investment is likely to be crowded out in national budgets, this program represents a major commitment to growth-oriented public-sector investment.

The EU’s cohesion strategy is admirable and smart. Whereas such investment in the past was heavily tilted toward physical infrastructure, the agenda has shifted to a more balanced set of targets, including human capital, employment, information technology, low-carbon growth and governance.

That said, one can ask what the economic and social returns on these investments will be. True, sustaining high growth rates requires sustaining high levels of public investment, which increases the return to private investment, in turn elevating output and employment. But public investment is only one component of successful growth strategies. It will do some good in all scenarios, but its impact will be much larger beyond the short term if other binding constraints are removed.

Three complementary issues seem crucial. One, mainly the province of the European Central Bank, involves price stability and the value of the euro. The second is fiscal and the third is structural.

Inflation rates, now well below the ECB’s 2 percent annual target, are in the deflationary danger zone. Because deflation drives up the real burden of sovereign debt and public non-debt liabilities such as pension systems, its emergence would undermine the already fragile state of many countries’ public finances and kill growth.

In a post-crisis environment of aggressive and unconventional monetary policy in other advanced countries, the ECB’s less aggressive policies have resulted in an exchange rate that has damaged competitiveness and the growth potential of many eurozone economies’ tradable sectors.

The ECB understands this, and, without being explicit about it, is expanding its asset-purchase programs to elevate inflation and bring down the euro. ECB President Mario Draghi has been clear that restoring target inflation and weakening the currency is not a growth strategy. Difficult reforms are needed to put many national economies’ fiscal affairs in order and to increase their structural flexibility. The ECB cannot do it alone.

On the fiscal side, sovereign-debt levels are too high and still rising. But the bigger challenge are the unfunded non-debt liabilities in pension funds and social-security systems, which are estimated to be four times or more the size of sovereign debt. It is clearly necessary to implement credible plans to arrest the growth of these liabilities.

But these liabilities also have to be reduced, because they are already imposing a crushing fiscal burden, largely owing to rapid aging, with rising longevity a major contributor. The United States has a similar problem, though it is more distant. A recent analysis for the United States suggests that entitlement programs’ liabilities will hit the public budgets in about 10 years.

Growth would reduce this burden, but growth in the short and medium term is highly problematic. Inflation would reduce the real value of both debt and other non-indexed non-debt liabilities. But even controlled inflation at higher levels has been ruled out; again, the current risk is deflation.

Governments could raise taxes to cover a larger fraction of the required expenditures. But that is not likely to help growth, and it imposes the burden on the workforce and the young who are trying to enter it, a valuable subset of whom are mobile and could simply leave. Likewise, issuing more debt to cover the portion of liabilities coming due would merely shift the composition of liabilities without reducing them.

The only other alternative is direct reduction. For sovereign debt, that means default, which will happen only in extreme circumstances; for non-debt liabilities, it means changing systemic parameters - for example, increasing the retirement age - which is contentious and exceptionally difficult to do politically.

The third missing ingredient is structural flexibility, which is needed for two reasons. First, most advanced economies have maintained the unbalanced growth patterns that led to the global crisis in 2008. Restoring growth requires structural changes.

In the United States, though growth remains well below potential, data suggests that about half of the recovery in growth has resulted from a shift in capital and labor to the tradable side of the economy, with shale gas providing a big boost. That is either not occurring or happening at a glacial pace in southern European economies, where structural rigidities in labor and services markets need to be addressed.

Even without crisis-related imbalances, structural flexibility in all economies is necessary to adapt to the changes caused by globalization and the labor-saving and skill-biased technological shifts associated with the rising value of digital capital. In the past 30 years, the global economy added 1.5 billion new connected workers in developing countries, with three billion new consumers in sight.

Europe has a real chance to conclude a bargain: member countries implement fiscal and structural reforms in exchange for short-run relaxation of fiscal constraints - not to increase liabilities, but to focus on growth-oriented investments to jump-start sustained recovery. Private investors would take note, accelerating the recovery process. The challenge now is to seize the opportunity. Copyright: Project Syndicate, 2014.

*The author, a Nobel laureate in economics, is professor of economics at New York University’s Stern School of Business and senior fellow at the Hoover Institution.

by Michael Spence