The EZ’s adjustment gamble

by Jean Pisani-Ferry on 25th January 2012


The battle for the survival of the euro area is being fought in Italy and Spain. Both countries’ borrowing conditions deteriorated in the second half of 2011. Both are so large – accounting for 17% and 11% of euro area GDP, respectively – that financing them through multilateral assistance would strain, if not exhaust, the resources of the euro area and the IMF. Both recently installed new, reform-minded governments. And both are struggling to rebuild competitiveness, foster growth, restore fiscal soundness, and clean up banks’ balance sheets. If they succeed, the euro will survive; if they fail, it won’t, at least in its present form.

Policy discussions over the last few months have largely, if implicitly, been about how to support adjustment and reform in these countries. Proposals to let the ECB intervene more decisively in bond markets, or to increase the size of the “firewall” through leveraging the European Financial Stability Facility (EFSF), were intended to set an upper limit on interest rates paid by Italy and Spain on their debt emissions. Similarly, proposals to create common bonds were intended to quell expectations of insolvency by ensuring that these countries would eventually be able to borrow against their euro area partners’ guarantee. All of the discussions were couched in general terms, but everybody had the same specific countries in mind.

None of these proposals, it seems, will be implemented anytime soon. Rather, Europe is putting in place a new fiscal compact to ensure countries adopt and implement stringent budgetary rules. These choices partly reflect pragmatic concerns: all of the financial-engineering schemes that have been proposed to protect Italy and Spain from aggravated borrowing conditions raise legal, political, or governance difficulties. But they also result from a strategic decision: it is thought (particularly in Germany) that protection from market pressure would only impede adjustment and reform and that only serious strains provide the required incentives to overcome domestic political and social obstacles to slashing public spending and reforming labour markets. For Southern Europe, no pain means no gain: a deep recession and a sharp increase in unemployment may be the price of lasting improvements in productivity and competitiveness.

This reasoning is not without justification. Soon after the ECB began buying Italian bonds last August, then-Prime minister Silvio Berlusconi’s government backtracked on its commitments to tax reform. Even though it later reversed its stance, the episode was widely regarded as clear evidence of the moral-hazard effect of ECB support. Only after the bond market turned on Berlusconi again was he replaced by the reform-minded Mario Monti.

But the strategy is a high-risk gamble. Governments may need incentives to act, but they also need to be able to show their citizens that reform pays. If, after a few quarters of fiscal adjustment and painful reform, output is lower, unemployment higher, and the outlook darker, governments may soon lose public support and reform may stall, as we have seen in Greece. Reform-minded teams may lose power to populists. Furthermore, a degraded macroeconomic and financial environment increases the likelihood of bank failures, with immediate consequences for public finances and economic confidence.

These risks are compounded by the need for reform in several countries at once. There is indeed a fallacy of composition in the current approach. Southern Europe accounts for one-third of the GDP of the euro area. Add France, which is also in need for budgetary adjustment and structural reform, and the total exceeds 50%. True, competition for investment is an incentive to act. But macroeconomic and financial interdependence may render success elusive if reforming countries face a dark regional environment of stagnating or falling demand.

We should be wary of the risk of a fallacy of composition. It is one thing to believe that governments act only under pressure, and that societies accept reforms only if they believe that there is no other alternative; it is quite another to believe that adjustment and reform will proceed if all of Southern Europe is struggling with recession. Keeping Southern Europe on a short leash will only be a credible strategy when accompanied by a comprehensive and effective growth programme for the entire euro area.

In part growth may come from a more supportive ECB policy and a weaker exchange rate. As growth falters and prices adjust downwards, the central bank may soon be perceived as emulating the Federal Reserve’s commitment to near-zero interest rates for an extended period, and the euro-dollar exchange rate should weaken. For Northern Europe this should mean more external demand and, depending on the world environment, higher domestic inflation. As long as average inflation in the euro area remains on the 2% target, these developments should be accepted – even welcomed – because they contribute to the process of internal adjustment. What the euro area needs in the years to come is inflation above 2% in the North and below 2% in the South, with the average at 2%.

The budgetary strategy matters too. To succeed, the broad pattern of consolidation should involve vigorous adjustments in Southern Europe and more guarded ones in Northern Europe, where the underlying situation is better. Northern Europe should not depart from policies that put the public debt ratio on a declining path but it should not consolidate more aggressively than needed, nor use budgetary policy to quell domestic demand and upward wage/price pressures. It is also important that budgetary targets are formulated in terms of efforts, not outcomes; in conditions of faltering growth or recession, the right approach is to stick to a medium term retrenchment path, not stack successive packages with the aim of reaching a specific short-term deficit target. Last but not least, the composition of adjustments matters greatly. It is worrying that throughout Europe, recent consolidation plans have been biased towards short-term fixes like increases in tax rates and indiscriminate spending cuts, which are detrimental to medium-term growth.      

The last component of a growth strategy is structural. Much here has to be done at national level, but the European dimension should be neglected. The EU should first play a role in evaluating policies and promoting best practices – a role it was meant to play within the framework of the Lisbon strategy but which, in part due to the member states’ reluctance, it hasn’t played very effectively. It should also mobilise the array of instruments at its disposal – from the EU budget, including regional development funds, to regulatory policies and competition policy – and prepare initiatives that can contribute to foster growth. Europe cannot afford to keep on running EU-level policies as if nothing had changed in its order of priorities. Because absent growth in Southern Europe, the EU itself could soon be in danger.

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